Have you ever been confused about something that should be perfectly clear?
Like the ongoing mystery of semi-boneless ham: does it have a bone…or not?
I think a lot of investors are confused about why cap rates on some value-add deals are lower than cap rates for similar stabilized deals. With the help of my friend and fellow BP author, Brian Burke, I’ll try to solve this mystery in this post.
Please note that this issue goes much deeper than just solving a riddle. This speaks to the whole strategy of buying value-add vs. stabilized properties. It delves into the thesis for buying and optimizing properties with hidden intrinsic value.
As I’ve discussed in many posts, this thesis is critical in times like these, where the real estate market has soared to new heights, and some investors are overpaying. Acting on Brian’s advice can help you make a profit and build wealth in any market climate.
What is a cap rate, anyway?
This confused me in my earlier years as a real estate investor. The cap rate is a measure of market sentiment. It’s generally calculated as the unleveraged rate of return on an income-producing property. Here’s the formula:
Cap Rate = Net Operating Income ÷ Value
The cap rate is generally outside the commercial syndicator’s control. It is like the price per pound when buying meat. It is the price per dollar of net operating income (NOI).
Some ask how to calculate the cap rate for a property they want to invest in. You can estimate this as the unleveraged return for a property like this in a location like this at this time and in this condition. You can learn more about the cap rate in this post.
A lower cap rate for the same asset means a higher property price. And vice versa for a higher cap rate. So when comparing different assets, one would think the cap rate for a stabilized property is lower than a value-add property. Here’s an example with the reasoning:
Tanglewood Apartments is fully stabilized and…