When I buy apartment buildings (or help other people buy them) I am ruthlessly focused on the cashflow they generate in year one.
I don’t factor in rents increasing, nor do I factor in price increases stemming from rent increases. I want to know what the cashflow is RIGHT NOW.
Many buyers to factor in rent increases and price increases. They look at a 4% cap, factor in some rent increases, and assume they can exit at a 4% cap in five years. Here’s the math: Let’s say year one rents are $250k and net operating income (NOI) is $162,500. You buy the building for $162,500 / .04 = $4,062,000.
These buyers then assume 3% / year rent increases. In year five, they assume rents will be $281,000 and NOI will be $183,000. If you 4% cap that NOI, you get $183,000 / 0.04 = $4,572,000. So you’ve collected a bunch of cash and your building is worth $500k more than when you bought it. Sounds great, right?
Ah, but what happens if interest rates on multifamily assets increase from their current historical lows? Say they go from 4% (where they are now) to 6%. That probably means cap rates are going to go from 4% up to at least 6%, maybe more.
If you 6% cap the $183,000 NOI in year five, you get a building valuation of $3,050,000. In other words, you vaporized $1,000,000 in asset value, even accounting for the 3% annual rent increases.
It’s important to understand that the above is totally irrelevant as long as you’re happy with the in-place cashflow and have no need to sell quickly. In that situation, you just hold the building for longer and collect the rents until some combination of rent increases and cap rate compression eventually takes your building value back up over par.
But if you’re investing with someone who is slinging a “we’ll buy and hold for five years and then get out” strategy right now, I advise you to give all the tires a good kicking.