The Urbana deal was extremely complicated, and you can’t simply define it by a going-in cap rate (although it was fine). A cap rate is based on net income, and the net income on this deal has a huge swing from day one to day 365. The rents are massively under market and the number of vacant lots that we can fill is huge. At the same time, the market is extremely hot and the quality of these parks is outstanding. When you buy a stabilized park with the only upside being the annual rent raise, then the going-in cap rate defines the deal. But in a turnaround, the cap rate could be negative going in, and it doesn’t even begin to tell the story. Many of the deals we buy are like that. Do we recommend others buy these type of turnarounds? Absolutely. But you have to become very flexible going in to do so. That would be like somebody going to an auto auction and buying a classic Ferrari that has no engine. Sure, it’s not running good now. But it still might be a fantastic deal. But you have to go to the end of the movie and work backwards to define how good it really is.
Would we buy a stabilized park with upside at an 8% cap rate? Absolutely. That would give us a three-point spread over financing, and we can raise the rents to ultimately beat 10%. The whole point of buying parks is the spread, not the cap rate. When we wrote the book, prevailing loan interest rates were at about 7%, hence the 10% cap rate fixation. But nobody ever expected interest rates to plunge and to be doing 6 point + spreads on parks. On a sample $1 million deal purchased at a 8% cap rate and with 20% down and a 5% bank interest rate, the cash-on-cash return is 20%, which is the target of most every buyer.
If you find a deal that has great infrastructure and is in a great market, but is priced at an 8% cap rate, and you can put it on a 10 year note at 5%, then buy it. Assuming you raise the rents 5% per year, you’ll be at 50% higher rents by the end of the loan, which will give you a great cap rate to either sell or refinance. If you find a deal with those same dynamics but a ton of upside in rent increases and occupancy, then pounce all over it.
The Fed plans on raising interest rates by two points over the next two years. The head of the Fed in Chicago spoke on this exact topic at the NCC event recently. When that happens, 10% cap rates will be, once again, the target. Remember that interest rates have never been this low this long in U.S. history, Here’s an article and chart of interest rates over the past 5,000 years:
As you can see, we are the lowest in 5,000 years. What does this mean as a buyer? You need to be flexible but with the ability to adapt to the market going forward. That means you have to lock in your loan for a long time at a fixed rate, and then push, push, push rents and occupancy – as well as cost cutting – to make sure that you can raise net income to take into account where interest rates normally are and meet that challenge. And if rates do not go up 2 points because of world economic weakness, then you hit a home run.
One final note as an amateur economist. When you look at the chart of the past 5,000 years, you’ll note the rates under Reagan. Bear in mind that when Reagan raised the rates into the teens, the U.S. had $900 billion in debt. Today it has around $19 trillion in debt – about twenty times more. If rates were to go up more than a couple points, the U.S. would be driven into immediate insolvency. I think the range of interest rates that you need to focus on is around 5% now and around 7% in two years or so. I don’t see it going much over that. If it does, then we may go back to a hunter/gatherer society.