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I have been thinking about this concept a lot lately given where "high quality" assets, predominantly multifamily and industrial, have been trading recently. https://twitter.com/PinkPoloShorts/status/1277620364118499329">https://twitter.com/PinkPoloS...
I& #39;ve been seeing a bias towards a lot of higher-cap rate assets with the sentiment being that you& #39;ll make higher cash returns and hold longer, so who cares about residual value. I think there& #39;s a fallacy in that argument - higher cap-rate assets trade that way for a reason.
Either they are lower quality physical real estate, they are in locations that do not have strong prospects, or they are of a size that limits the potential buyer pool (i.e. too small for a professional investor).
Yes, your cash on cash return is higher, but there is significantly more risk to the stability of those cash flows. Now here& #39;s where you are going to say "but I& #39;m below replacement cost, no one can compete with me on price".
If that& #39;s the case that also means there& #39;s likely not going to be significant rent growth because if there were, it would attract more supply. Here& #39;s where you have the risk to your cash flows...
If you purchase an asset at a 8 cap, and make a 12% levered cash return, and you sell it for what you paid for it, you make a roughly 12% compounded return. However, if you can& #39;t grow rents, your operating cost growth at stabilization is going to outpace your rent growth.
Which means that your NOI ultimately declines. Eventually, and this differs by asset class, you& #39;ll be forced to put capital back into the asset to make it more competitive. Here& #39;s where you say "there& #39;s no new supply so I don& #39;t need to renovate".
Problem there is that it kills your residual value. If the quality of the real estate degrades, your appraised value won& #39;t be where you think it is, or no buyer is going to take you out at the cap rate you thought. Now maybe you& #39;re selling for less than you paid.
Even if you took a lot of cash out, that kills the ultimate return. And we& #39;re back to the reason that you were able to buy at a high cap rate in the first place - you bought an asset that, for whatever reason, was challenged and undesirable.
Now there& #39;s lots of value in re-investing the cash you make elsewhere - that& #39;s a different conversation. Further, there& #39;s a risk that the cap rate environment moves against you. There is such a thing as cap rate expansion, and you& #39;re more at risk the worse quality RE you have.
10 years ago select-service hotels trading at 12 caps, storage trading north of 10, and suburban multifamily trading north of 7. It can happen. Yes, if you don& #39;t sell it may not impact you immediately, but you need to refinance at some point, and a cash-in refi is a return killer
