When a renter or home buyer selects their next home it's usually a decision with a lot of emotions involved. Do you like the layout? How does the landscaping look? Will your kids be safe in that yard? Will you be able to take care of it when you get older?
In contrast, when a landlord buys a building this is generally not the case. While there may be some emotion involved it is considerably less than what comes into play when you're actually going to live in the property with your family or friends. When a landlord buys a large building it is a financial investment. As one of my mentors once said, "Home buying is 10% logic justified by 90% emotion, but commercial investments are 10% emotion justified by 90% logic."
Experienced landlords and renters will have very different perspectives on the same building. It's my opinion that these opposing viewpoints lie at the heart of a lot of landlord-tenant conflicts. So today in the interest of learning about how the other half shops for buildings we will dip a toe into the thought processes of how a landlord goes apartment hunting. Don't worry, I'll be starting off easy without too much math or economics.
Now before we get started I want to make clear that this logical approach does not always apply to all landlords. In particular, landlords who buy small buildings such as two-flats with the intent to occupy one unit themselves fall in more with the home buyers and renters. In Chicago they are accordingly served by Realtors who are trained to deal with the emotion and thought processes that accompany residential purchases. We're not talking about them today.
We're talking about commercial investors for whom a property purchase is entirely an investment decision. These folks are served by commercial brokers who are trained more heavily in financial analysis than their residential Realtor peers.
Rules, Guidelines and Rates, Oh My!
Those of you who have gone through an owner change in an apartment building may have been surprised that the property sold. You may have never known it was even on the market. There were no "For Sale" signs out front and no showings. This is because for a landlord what's more important is how the building performs on paper.
If showings occur, they involve the inside of apartments. To a certain extent this is to minimize panic among the residents, who tend to move out if they know an owner change is imminent. But more importantly, the interior of the apartments don't really matter to the landlord, even if you have really nice furniture. Rather, they look at the exterior walls, the roof, the foundation, the porches, the boiler rooms. If they do view an apartment it will probably be an empty one, and only to inspect the condition of the windows. To a landlord these elements of the physical structure are far more crucial, as they will be the largest expenses to repair or replace should they purchase the property. Renovating an apartment interior is relatively cheap. Replacing a roof is not.
But it is also possible for a commercial multifamily investor to buy a building sight-unseen and be entirely comfortable with their purchase. This is because the majority of their decision is based on review of the financials, capital improvements and preventive maintenance. ("Capital improvements" is the business term for big ticket changes such as replacing the windows or roof.)
When analyzing the financials of a building landlords use a ton of different metrics. If you browse around landlord discussion boards like BiggerPockets you will see mention of 20% rules, 50% rules, Internal Rate of Return and Financial Management Rate of Return. As with any type of investment, each property investor will use their own combination of the conventional formulas and even their own secret calculations to justify their purchase and convince themselves that they are getting a good deal. But the one formula that pops up in almost every multifamily investor's analysis is the CAP rate. This is because it's very easy to calculate, but also because it says so much about a building and its surroundings with a single number.
Put On Your Robe and Wizard CAP.
For most renters, when they hear the word "capitalization" they think about grammar. For investors of any type (stocks, bonds, small businesses, real estate...) it refers to profit earned from an investment. The Capitalization Rate, or CAP Rate, of a building is a quick measure of how long it will take for an investor to recoup the purchase price. The higher the CAP rate, the less time it takes to start turning a profit.
To calculate the CAP Rate of a building, you take the annual income, subtract your operating expenses (such as payroll, leasing agent fees, maintenance costs) and then divide the result by the purchase price. It's very easy math, and for someone with even a year or two of experience in property investment it's something they can do in their head.
Let's try an example.
Suppose that you know that you usually spend about $15,000 per year on expenses for a 5 unit building. You see a 5 unit building on the market for $300,000. It has all 2 bedroom apartments that rent for $1000 per month.
The annual income for the building would be $1000 x 5 x 12, or $60,000. Subtract your $15,000 operating expenses and you get $45,000 net annual income. Divide that by the purchase price of $300,000 and you get 0.15, or a 15% CAP rate.
Now suppose you see another 5 unit building listed for $700,000. It also has all 2 bedroom apartments that rent for $1000 per month. You try doing the math this time. You should end up with a 6% CAP rate, or to use the slang, a "6 CAP."
Finding a CAP that Fits.
Each investor will have their own threshold of what is acceptable for them as a CAP rate. Some of them take "buy and hold" approach, planning to keep buildings in their portfolio for decades or more and earn most of their income from rents. They will usually want a high CAP rate so they can get to that profit point quickly. Others are "flippers" who plan to make most of their money by improving a building and then selling it at a profit. Flippers will have higher operating expenses, and their CAP rates will be much lower accordingly. But they do not plan to hold on to the building for long enough to fully capitalize it, and if they do, they'll have improved the quality of the units enough to justify raising rents.
Beyond each investor's own personal threshold of acceptable CAPs, each neighborhood has its own average acceptable CAP rate. Areas with high demand (think downtown Chicago and any neighborhood that's dealing with gentrification) can have much lower CAP rates and still attract investors. Areas known to be bad neighborhoods must offer properties with very high CAP rates or nobody will be interested in buying buildings there.
To give more concrete examples, in posh Chicago neighborhoods like Lake View and Lincoln Park the average CAP rate for multifamily purchases hovers around 4%. In contrast, the average CAP rate in the roughest Chicago neighborhoods can easily exceed 20% or even 30%.
Cause or Effect? Yes.
Those of you who are concerned with issues like affordable housing, gentrification and segregation will immediately draw connections between these issues and CAP rate. The average CAP rate for a neighborhood affects the caliber of landlords who buy there. This in turn affects the rent rates and the way buildings are treated. If the only investors who will buy into a neighborhood are flippers, then you can be sure that rent list prices will be skyrocketing beyond the point of affordability very soon. Some of these increases will be successful, some will not.
It's important to mention here that investors are not the only ones to use CAP rates. Another very important group of people in the property investment business also use them: the mortage lenders. If you're going to borrow money from a bank to buy an apartment building, the bank wants to be sure that it will get paid back. If a bank looks at a building you intend to purchase and see that it's in a very high CAP area, they may say, "alright you can have the money but you have to pay us back in 10 years instead of 20." Or they may say, "there is absolutely no way you can make this work, you will lose money on it, no you cannot borrow ours." Then you wind up with a building or neighborhood that can only be purchased by someone with enough cash to do it without a loan. You know who tends to have a lot of cash on hand an interest in buying a 12 CAP building? Slumlords who already have an existing portfolio of 15 CAP buildings.
Even so, CAP rates do not determine the quality of a neighborhood and its housing stock. The neighborhood itself does that and CAP rates respond accordingly. But the CAP rate once set can more firmly enforce trends of neighborhood improvement or decay by attracting certain types of landlords. It is a cycle that takes an enormous effort to break. It may in fact be impossible to bring a 30 CAP neighborhood down to a 4 CAP. All of the tumult and upheaval in the West Town area (Wicker Park, Bucktown, Ukrainian Village, etc) only served to nudge it from around an 8% CAP Rate down to its current 4%.
There are ways to make large changes to a neighborhood's CAP rate but it often involves some creative changes to neighborhood dynamics or architectural trends in order to temporarily attract investors from niche markets. The enormous surge in popularity on the Near West Side for example is linked to the sudden surge in interest in the "true loft" decor style. The multi-year trend of renters and homeowners who wanted to live in converted factories allowed investors who would normally avoid the area to enter via the purchase of industrial property instead of existing residential buildings. Albany Park is seeing some upheaval lately following the construction of on-campus dormitories at Northeastern Illinois University. This shift will push some of the landlords who specialize in student housing out of the neighborhood, making way for a different group to take over their buildings.
So if you're concerned about affordable housing then do not point the finger at CAP rates exclusively. To do so would be like blaming the measuring tape when your hips are too wide. However, to continue that peculiar analogy, if you don't take action to lose a few pounds it's unhealthy for you as a person. Likewise, if a neighborhood does nothing in response to a high CAP for too long it's unhealthy for the neighborhood.
Unfortunately there is no real way for your average individual to obtain data on the average CAP rate for their area. In fact, given the separation within the industry, even your average residential Realtor wouldn't be able to obtain the info for you, since many commercial property transactions are never entered into any of the data sources accessible to them. You'd have to connect with a commercial real estate agent or a commercial mortgage lender who specializes in the area to find out the numbers.
In closing I want to mention that this article is something of a test balloon. I can certainly do more on the landlord side of things but I'm no financial analyst (obviously) and I am not sure if you find the content to be of interest, no pun intended. Let me know what you think, please? Thanks for reading and I'll see you next week!
