Most people think there are two options when buying rental property. Option A is to buy in a hot market with little to no cash flow and wait for appreciation. If you’ve been listening to the BiggerPockets Podcast for a while, you know this method is frowned upon by most investors here. Option B is to buy in a market with good cash flow, even if you don’t see much appreciation.
But what if there were a third option? What if you could combine cash flow with great appreciation? Well, you can!
Before we get into that third option, let’s talk for a minute about cap rates and why the first two options exist.
A cap rate, short for “capitalization rate,” is the relationship between net operating income (NOI) and purchase price (purchase price divided by NOI). If you have a low cap rate, you’ll pay more for the property and get less cash flow. A high cap rate means you’re paying less for the property and have more cash flow.
For this discussion, we have to assume investors are rational. We can debate that assumption in the comment section, but for the most part, large institutional investors are rational, and they’re the ones setting prices.
Now, why would someone be willing to pay more for a property and get less cash flow, i.e. low cap rate markets?
If a market has great fundamentals, including population growth, job growth, rent growth and high occupancy, an investor is willing to pay more for income generated by a property than they would in a market that doesn’t have those fundamentals. That’s because there’s future upside that’s not being accounted for in the current income. Let me say that again: Investors are paying more because there’s potential for income growth.
So, if you see a low cap rate, that means people are paying more for the same income, and it’s likely that this market has good fundamentals. Markets where people are moving to in large numbers (think Phoenix, Seattle, Austin, and Charlotte) have low cap rates. Conversely, in high cap rate markets where investors are paying less for that income, the market likely doesn’t have great fundamentals. Josh Dorkin would probably give an example of Detroit here.
Now, here’s where value-add comes in. What if you could buy in a low cap rate market—so somewhere with strong fundamentals and a high likelihood of appreciation—but still get cash flow? Ben Leybovich and I just did exactly that on a recent deal here in Phoenix.
Phoenix has great fundamentals. It’s number two in the country in population growth amongst large cities. Rent growth for 2018 is near 7%. Phoenix is adding jobs twice as fast as the national average. So, it should come as no surprise to you that Phoenix has cap rates under 5%. We just bought a 98-unit apartment at a 4.75% cap rate. That probably sounds crazy to some of you, but I can assure you we’re excited about it! Why? Because after our $1.4 million renovation, we’ll be able to increase rents by over $300. That will bring our cap rate to over 8%! What’s more, we’ll still get the benefit of being in Phoenix, and all of the potential upside that comes with it. As the population continues to grow, we continue to add jobs, and rents get even higher.
That delta we create in the cap rate (sub 5% to over 8%) through value-add projects is what allows us to buy in a hot market and still get cash flow. Now, as this method gets more popular, that delta will continue to shrink. Some of the big value-add investors in Phoenix last year have already moved on to places like San Antonio because of competition. It might take longer to find a property with that large of a delta in Phoenix, but if you can find it in the hottest markets, i.e. great fundamentals, the payoff can be huge.
Another reason a value-add deal can be more rewarding in a hot market than a mediocre market is the amplification of your increased income. If I’m in a market with a 10% cap rate and I increase income by $100,000, the value of my property increases by $1,000,000. However, If my market is at a 5% cap rate and I increase my income by the same $100,000, the value of my property has now increased by $2,000,000! The lower the cap rate, the greater the amplification of your value-add project.
We’ve been told for years that it’s all about cash flow. Appreciation plays are too risky. Well, I’m here to say it’s about creating cash flow in a market that will give you plenty of upside and appreciation. You can have your cake and eat it, too.
Do you invest primarily for cash flow, appreciation—or some combination of both?
Weigh in with a comment!