Why Cap Rates Can Sometimes Be Misleading By Dave Reynolds

Cap rates are the generally accepted method of comparing different properties and sorting piles of listings into the “make offer” and “don’t bother to make offer” stacks. But cap rates can be misleading in some cases – especially when you are buying properties from non-professional owners who have not been operating theproperty to its full potential.

Going-in cap rates are often based on flawed operating numbers

You would typically expect a seller to maximize net income before placing a property on the market — but that’s not always the case. Often the seller has failed to perform market rent analysis annually, and has set their rent at low levels that are not warranted. They may also have piles of vacant community owned homes as the result of a general lack of marketing effort or willingness to renovate them. And in some cases the property labors under the weight of expenses that could be reduced substantially with no ill effect on the property or its operation.

Many properties offer significant rent increases or utility bill backs in the near term
If target properties are not being operated correctly, then the near-term performance is subject to immediate improvement if you simply fix what’s broken. Typically, that is a combination of raising rents, making residents responsible for their own utility costs, filling vacant community-owned homes, and cutting unnecessary costs. Some of these changes can be staggering in net effect. We purchased a property in Austin that had $250 lot rents in a $500 market. We acquired a property that was burning $5,000 per month in water leaks. These items can boost your cap rate up two to four points
within 90 days of purchase – and take that 5% cap rate to a 8% cap rate as a result.

But be careful when you include factors you don’t control

Raising rents, metering utilities, filling homes and cutting costs are very achievable as there is nothing to hamper you from successful completion. These are completely within
your control, assuming there are no laws or ordinances to preclude them. However, not all methods to increase net income are as simple. Filling lots can be capital intensive and you have to really understand your potential customer base and fine tune to get the right fit, which can be time intensive – so you would not want to make any wild assumptions on the speed in which you can fill vacant spaces and the impact on cap rate. Similarly, filling RV lots in some markets requires getting just the right marketing effort in position, and you can never predict how long it will take, or if it will work at all.

And don’t make assumptions that are not based on scientific fact

If you do the lot rent comps in a market and find that $240 per month is the standard rent, then don’t use the assumption that you can raise your rent to $300 day one. If it will take you two weeks per vacant home to renovate, show it and sell it, then don’t assume you can knock out six in two weeks. Remember that you cannot alter the facts to meet your own goals. Being conservative in your estimates is always prudent and will save you from embarrassment when your performance misses your estimates. Try to be a scientist in a white lab coat when it comes to planning your budgets on how you will turn the property around and do not let emotion play any part.

Case study: a recent Texas acquisition

We recently purchased a property in Texas that is a good illustration of how the seller’s cap rate can often be deceiving. The property is 94% occupied in a metro of nearly
7,000,000 people, where the median home price is a healthy $150,000+ and the three-bedroom apartment rent is nearly $1,300 per month. The market lot rent is $400 per month net of utilities. Despite these facts, the seller’s lot rent is currently $325 per month including all utilities, which yields a going in cap rate of roughly 8%. While that’s not bad by itself, installing sub-meters and making the residents pay for their own utilities (which is the norm in this market) increases the cap rate to around 10% — and that can be accomplished in roughly 120 days. In the following two to three years, the
lot rent can be increased to the market norm of $400 per month, which yields a 12% cap rate. So in two steps, fully within our control and supported by scientific market data, we can increase the cap rate from 8% to 12%, and the deal goes from being good to spectacular.

Conclusion
Sellers mean well, but their estimate of potential net income is often far off the mark when professional property management skills are employed. Always make sure to
review the seller’s assumptions that support their announced cap rate, as there is frequently room to increase net income substantially. It would be a shame to miss out on a great deal  just because the seller’s cap rate appears unappealing, when actually you can push that cap rate way above your normal buying threshold!

Dave Reynolds has been a manufactured home community owner for almost two decades, and currently ranks as part of the 5th largest community owner in the United States, with more than 23,000 lots in 28 states in the Great Plains and Midwest. His books and courses on community acquisitions and management are the top-selling ones in the industry. He is also the founder of the largest listing site for manufactured home communities, MobileHomeParkStore.com. To learn more about Dave’s views on the manufactured home community industry visit www.MobileHomeUniversity.com. This article originally appeared in the Manufactured Housing Review, subscribe for free here.

 

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