JF1347: How Important Are Cap Rates In Apartment Investing? #FollowAlongFriday with Joe & Theo
The guys are back with another great topic. Hear why Joe doesn’t think cap rates are the best area to focus on with large apartment communities. We also get updates on their investing and how what they have learned in the past week can apply and help our businesses. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!
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Joe’s interview with Brian Burke: https://joefairless.com/podcast/jf305-why-you-should-look-at-the-numbers-last-when-evaluating-a-deal/
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Joe Fairless: Best Ever listeners, how are you doing? Welcome to the best real estate investing advice ever show. I’m Joe Fairless, and this is the world’s longest-running daily real estate investing podcast. We only talk about the best advice ever, we don’t get into any of that fluffy stuff.
We’ve got Follow Along Friday today, I’m with Theo Hicks… Theo, how are you doing, my friend?
Theo Hicks: I am doing amazing, Joe. I’m glad to be here.
Joe Fairless: Well, I’m glad you’re doing amazing, and I’m also equally glad that you’re glad to be here. We’ve got some listener questions, we’ve got some updates, and we’ve gotta get going… So how should we approach it?
Theo Hicks: This question came in from a couple of people over [unintelligible [00:01:35].07] wanted to address it. It’s about cap rates, and the question the listeners asked is basically “Why do you look at cap rates for apartment investing?”, but for our conversation today we’re gonna answer the question “How important are cap rates when investing in apartments?” and “Is it the most important thing, or is there other things that we should be focusing on instead?” So I’ll just throw that out there and let you answer that question, Joe.
Joe Fairless: I was a keynote speaker at the Philadelphia Conference that Dave Van Horn put together. Tremendous conference; I’ve mentioned it before on the show. I highly recommend going to it next year in Philadelphia, assuming that he has it next year, which I think he will… And I addressed this question in my keynote; so if you went to that conference in Philadelphia, then just fast forward to the next topic we talk about… But if you did not go to that conference and you didn’t hear this, then it’s beneficial, especially for apartment investors.
The question I get decently often from accredited investors who are looking at our deals, or who are talking to me prior to me sharing a deal with them and they’re just wondering about the type of deals we buy, is about cap rates; they ask “What cap rate are you buying the property at?” or “What’s the cap rate that you typically buy a property at?”
That is a question, and it is a relevant question, but it is not the most relevant question. The most relevant question is “What is your business plan and team that you have in place to execute the business plan?” And the reason why is because cap rates can be misleading. I was in New York City about a month ago, visiting with investors, and I had a happy hour with a bunch of my investors, and had some dinners, and met up with some friends… One of the things I did is I met up with an investor, and he owns a hedge fund, so clearly, he’s financially savvy.
He owns the hedge fund; he’s got (I think) 80 people on his team (or at his company, hired), and he told me about a group he invests with in Manhattan. They buy at 2% cap. A two-cap! And at first, he said “Joe, man, I was so sticker shock… I was thinking how are you all buying [unintelligible [00:04:14].00] two caps, but then generating healthy returns.” So at first I was like, “No way. No, thank you.” But then I looked at it and I saw the healthy returns, and I was like “Okay, how are they doing this exactly?” In their case, the focus on rent-stabilized — is that the right term for New York? I can’t remember… You know, Theo, where you can’t raise the rent…?
Theo Hicks: I know what you’re talking about…
Joe Fairless: Yeah, it’s on the tip of my tongue… Shame on me. I lived in New York City for ten years and I’m forgetting the term right now. Basically, you can’t raise the rent, or you can raise it incrementally. I think it might be called “rent-stabilized”, I can’t remember. Anyway… They focus on those apartment buildings, and the reason why the focus on those is because it seems counter-intuitive – you need to add value, but why focus on an apartment building [unintelligible [00:05:08].15] to the market level… And the reason why they do that is they said there tends to be some shenanigans going on at those apartment buildings where the person who has the rents stabilized —
Theo Hicks: It’s rent control.
Joe Fairless: Rent control, thank you! I appreciate the Google search. Rent controlled apartment… In some cases, they will transfer that to someone else, so that the apartment still stays in their name under the original person, but in reality that original person is no longer living in there. So they have some sort of process; I think they do some electronic key card, or something like that; I didn’t really ask too many specifics about how they do the value-add. The point is that they buy these two-cap properties and they have a unique method…
And my investor said they have three ways to add value. The other two are pretty much what we do – renovate, increase the rent (if it’s non-rent-controlled). But basically, they’re increasing value through methods of a business model, and they have the team to execute the business plan… And they’re buying at two-caps, but then the cashflow is very healthy. I didn’t ask him the type of returns – I should have, but I didn’t. But he was happy with it, and again, he owns a hedge fund, so I figured they’re gonna be pretty good returns.
That’s a two-cap property, and if we were just to look at the cap rate, then that’s not the most relevant thing. When we do look at cap rates, I believe the relevant things to look at is 1) What’s the market at? So you wanna make sure you’re buying competitively, and ideally, you’re buying better than what the market is, at least competitively… But really, that money is made in these large apartment buildings with the business plan, and the execution of the business plan.
I believe with cap rates you also want to conservatively project that the economy will be worse when you sell, therefore the cap rate on your exit should be projected to be higher, and that should be factored into your project returns. You shouldn’t project that the cap rate will be the same, or definitely not lower when you sell. If it is, then bravo – you’ve just nailed your investment plan, because you projected it to be worse, which is higher when you sell, but in reality it’s the same or lower, so great! You did a great job and you made a lot of money for your investors, and you did, too.
So the question for — this is for passive accredited investors, or passive investors, as well as general partners who are putting the deals together… The focus and the emphasis, in my opinion, should be on the team, the execution, the business plan, the qualifications of the team, the historical track record of the team to execute on a similar business plan that the subject property is projecting to do… And when we do that, that’s where we add a ton of value, and that’s where the money is made or lost, in my opinion. Certainly, if you don’t buy it right, then that’s a problem, but let’s just assume you buy competitively, but then you have a phenomenal team to implement the business plan. Now you can turn a ten-cap into a seven or eight-cap on the financials, and then sell it at a very good price later at maybe a two-cap, or something.
Theo Hicks: Yeah, and I think this is great information especially today, because when I scroll through Bigger Pockets forums, or at my meetup I had last week, a common challenge people have is finding good deals… The cap rates are too low; I kept finding cash-flowing properties, and that — obviously, it’s important to buy at a good price and the numbers need to make sense, but you’ve got two investors looking at a two-cap property in Manhattan… Most people would look at that and be like “Oh, that’s just too low. I can’t make that work”, whereas this individual you’re talking about was creative and kind of had one additional strategy on top of what everyone else would do, and he could make those two-cap properties work. And if you’re able to do that, and identify ways to make those lower cap rate properties work, I would imagine that your competition would be a little bit lower, because people would automatically see — again, I keep going back to this two-cap example; they see that and they won’t even look at it at all. They’d be like “No, I’m not doing that…”
So for the people that, as you mentioned, have an extra way to add value, if they have a better team than someone else that has those strategies themselves, and things like that, and make deals work that other people wouldn’t even touch.
Joe Fairless: Just imagine you buy a two-cap property in Manhattan, you add the value, and then you sell at a 2,5% after you add all that value. That’s incredible! And there are investors who buy at a 2,5% cap or a 2% cap just to get a stake of New York City, and hold on to it in the long-run… Just cross your fingers, hope it appreciates, which it probably will. So you can buy at a low cap rate, add the value, and then if the cap rates stay around that range, you can destroy it; you can just do very, very well.
And conversely, you buy at a 7% or 8% cap, and you don’t have the right business plan – well, who cares what cap rate you bought it at, because you didn’t execute the business plan and the property is worth about the same that you bought it for, unless the cap rate just completely decreased and you just got lucky.
So the number one question, in my opinion, is the business plan and the team. Then the second – or the third, really – would be the cap rate, I guess. Maybe the second would be on the market. So I’d say the business plan, the team, and then the market, and then the cap rates kind of tie into the market, I guess.
I also wanna give credit to Brian Burke… My business partner, Frank – he created our underwriting process, and our underwriting spreadsheet and analyzer… So he has been doing this for 8-10 years, so he was clearly aware of this approach, but I didn’t consciously become aware of this approach initially until I interviewed Brian Burke. I don’t remember what episode that was, but just search “brian burke joe fairless”, you can go hear that episode. I think I’ve interviewed him twice, and it would be the first one. Grant can put that link in the Facebook thread for everyone to click… And then Grant, if you can put it in the show notes link too, for when this episode live…
That’s a great interview to listen to. Brian is a competitor of mine, but I don’t care; we live in a world of abundance. And he’s a great guy, and he gave some great information, so I wanna reinforce what he said, and promote him a little bit, because it was an interesting conversation.
So if you wanna learn more about this and you want kind of a follow-up conversation, then listen to that interview. Brian talks about why cap rates aren’t the leading indicator of if a property/project will be successful or not.
Theo Hicks: Yeah, I’ll have to listen to that.
Joe Fairless: You haven’t listened to it yet, Theo?
Theo Hicks: I’ll have to… [laughter]
Joe Fairless: Was that pre-Theo, maybe? We’ll say that was pre-Theo days, okay.
Theo Hicks: So just to wrap up, just to provide the others more resources for implementing the business plan properly, identifying value-add opportunities, make sure you guys check out a blog post in particular that talks about value-add; it’s “27 ways to add value to apartment communities”, so 27 ways that you could have a competitive business plan if you find a property with a low cap rate.
Then in regards to building a team, we’ve got 22 blog posts as of this moment on identifying credible experienced team members. Then in regards to finding the right market, we’ve got the Market Evaluation category… So just make sure you check out that; we’ve got a lot of resources that you can use to piggyback on this conversation.
Joe Fairless: And where do they go to check those out?
Theo Hicks: That’s just TheBestEverBlog.com.
Joe Fairless: BestEverBlog.com was taken, by the way. That’s why we have THEbestEverBlog.com.
Theo Hicks: It’s like THE Ohio state.
Joe Fairless: Right, right, yeah.
Theo Hicks: Fantastic. So just transitioning into some updates from this previous week… I had my meetup last week; it went well. I had a full-packed house. Everyone showed up, even though I had to change venues the last minute… So people walked in and said, “Oh, I thought it was at this other venue”, and they came kind of late–
Joe Fairless: How many people?
Theo Hicks: There were 13 people that came.
Joe Fairless: Awesome.
Theo Hicks: About half were return guests, half were new.
Joe Fairless: That’s what you want.
Theo Hicks: And actually, one of the guys there used to live in Los Angeles, and this cap rate conversation kind of reminds me of him, and I’ll have to direct him to this podcast, because one of the reasons he left California is because the cap rates were so low that he couldn’t find good investment properties. So he came here to Tampa, where they’re a little bit higher.
He is interested in apartment syndications, but doesn’t have the experience at the moment. When we first met, he mentioned that he would kind of find deals and then send them to me to take a look at them. He sent me a first batch of deals this morning, and I’m looking forward to taking a deeper look at those, and who knows, maybe one of those will be my first deals down here in Tampa.
Joe Fairless: Okay, so he’s sending deals to you… Are you reviewing these out of the kindness of your heart, or do you get some sort of stake in it?
Theo Hicks: No, so these would actually be deals that we would syndicate. So he is bringing it to us and we would give him — we would be able to negotiate what we would do; we haven’t really discussed that yet.
Joe Fairless: “We would syndicate”, “He is bringing” – so you’ve got another partner? So basically he’s a bird dog right now.
Theo Hicks: Yeah, exactly.
Joe Fairless: Got it, okay.
Theo Hicks: One of them is off-market, the other ones are on market. One of them looks interesting, just kind of reading through what he said, so I’m looking forward to diving more into that.
A quick update on my properties – we filled one of the vacancies… A one-bedroom for $625, and the old rent was $580. It wasn’t what we wanted to get exactly, but it still was an increase of $55.
The other unit is actually not rented yet, and we are considering lowering it to $610. The lesson I’ve learned – this could just be specific to this experience, but you can demand a higher rent by increasing the rents on existing tenants, as opposed to bringing in brand new tenants and listing it on the market, just because on the one-bedrooms that are basically renewed leases – we were getting $685 for those, but then when people left and we were bringing new people, we’ve got $625 and now potentially $610. So that’s just something I learned.
The two people that left, left because of the rent increases, so maybe that’s obviously the negative of it, but that’s just something I just observed and thought it was interesting.
Joe Fairless: Yeah, that is interesting.
Theo Hicks: And then finally, I’m going to a new mastermind meetup; it’s just gonna be three guys I met. One of them I actually met through the podcast; mostly everyone I meet down here is through this podcast. [laughter]
Joe Fairless: That’s awesome, I love to hear that.
Theo Hicks: It is really cool. They all said “Hey, Theo, I saw you on Follow Along Friday. I’m gonna be in Tampa this week” or “I live in Tampa”, so it is really cool, so I appreciate that, Joe.
Joe Fairless: You’re a part of it.
Theo Hicks: It’s a property manager, a wholesaler and a partner who are interested in apartments someday. My outcome is just to meet some people down here and have an extra layer of accountability to go there and tell them what I’m going to do, and then go back again and tell them how successful I was at doing that, as opposed to saying “I didn’t do it because of…” some excuse.
Joe Fairless: So you’re doing a mastermind with those two people who you haven’t met before?
Theo Hicks: I met one of them, and his business partner, and then someone else in the area that he knows and invited to join, and who agreed.
Joe Fairless: Cool. Well, let us know how it goes. I just wanna give a shout-out to my brother, who actually does not know that he helped me with this, because he said something in passing that has changed my approach to exercise… I have two brothers – one of them is a lieutenant colonel in the Army, and I was in town for a family thing about a month ago… He was there too, and he was talking to my aunt about his exercise routine, and he’s casually said this – “Yeah, four miles is a short run for me. That’s the minimum that I do”, and I thought “Dang…!” I’ve been doing 2, maybe 3 mile runs, and I used to do 6 in New York; I used to run from East Village, to East River, down to South Street, Seaport (I think), and then back up, and it was like 6 miles a roundtrip. And now I’m doing like 2-3.
I didn’t’ say anything to my brother, but it registered, and now I do minimum 4 miles runs, which some Best Ever listeners will be like “Dude, you’ve gotta still step up your game.” But what I needed to do was I needed to raise my standards. Tony Robbins talks about this a whole lot, raising our standards. We get what we must have, and we get what we get based on our standards that we have for ourselves. So I simply raised my standards… So little things like that, seeking out others who are playing at a higher level in certain areas of our life, and then raising our standards to their level can have big changes. I was looking at myself in the mirror today, and I was like “You know what, I’m skinnier today! I like it!”
I just wanted to mention that… A video that you can watch is just search “tony robbins raise your standards”, and you’ll have a good video for you.
Theo Hicks: Yeah. I can’t wait to go on a run after this now. It’s probably only gonna be a mile though, not four miles yet. [laughs] But that’s a good anecdote.
Alright, everyone… Just to finish off, make sure you guys go check out the Best Ever Community on Facebook; it’s BestEverCommunity.com. Lots of great conversations and information posted to the site. Each week we post a question, and based off that question we create a blog post, just because we think it’s a great idea to get 5-10 active investors answer these important questions, and then letting other people see how they perceive real estate investing.
For example, this week the question is “How much money do you need to get started investing in real estate?” So everyone go to the BestEverCommunity.com and answer that question, and you’ll be featured in the blog post. I’m looking forward to reading some responses. My answer is $0.
Joe Fairless: Yeah.
Theo Hicks: I’m curious to see what other people say and how they answer that.
Joe Fairless: My answer is $0, too. If you’ve read the story about the guy who went on Craigslist and had a paper clip and he ended up trading it eight different times (or however many times) and he ended up with a house in Alaska… [laughs] It’s just being resourceful. You need zero dollars to get started in real estate; you just have to have a degree of resourcefulness that is higher than people who have money… Which a lot of times, if you have no money, then you don’t have that higher degree of resourcefulness than people who do have money – because that’s how they got money – but that’s not always the case.
Theo Hicks: I appreciate that introduction to the blog post, about the paper clip to Alaska…
Joe Fairless: [laughs] Yeah, I love reading that story. Hopefully you can find something that validates what I just said. I’m pretty sure [unintelligible [00:21:03].09]
Theo Hicks: I’ve heard it before.
Joe Fairless: Well, it might be like an urban legend or something, but… Yeah.
Theo Hicks: And then make sure you guys go subscribe to the podcast on iTunes and leave a review; we really appreciate the feedback and the praise. If you do, you’ll have the opportunity to be the Review of the Week, which we’ll read live on the podcast, or with Facebook Live.
This week the reviewer’s name was DownloadKeelo – I’m not sure if he’s an artist or something, but… Their review title is “This podcast is filled with great info”, and they said:
“As someone who has been in PERE (which I believe is private equity real estate), doing multifamily for quite a while, and now branching out on my own, I figured I’d start listening to the podcast and see what insights others might have that I don’t yet have… And I have to say, Joe’s podcast is actually one of the best I’ve found.
It’s full of great information and great interviews, it’s a worthwhile listen for complete beginners all the way up to people who have invested at an institutional level, with plenty of stuff in between. Give it a listen!”
Joe Fairless: Wow, I am honored to have a review by someone who has played at a high level with private equity, and speaks highly of this show. Thank you for that comment and the review, and taking time out of your day to do so. And for everyone else, I would really appreciate if you do a review on iTunes, as I’ve mentioned every Friday. It will be helpful to attract quality guests and continue to do so… So thanks for that.
Thank you for spending some time with us. I hope it was a valuable exchange of your time for information that can help you with your business, and will have great financial returns for you as a result of you spending some time with us. We will talk to you tomorrow, thanks a lot!