Would you argue that smaller assets/properties could deserve higher cap rate compared to larger ones due to some risks associated with the smaller size? What could be such risks if there are any?
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Yes - smaller scale properties generally trade at higher cap rates than your standard institutional investment grade assets.
Take multifamily for example. Institutional investors generally go for over 200+ unit apartment complexes at anywhere between a 3.5 - 5.5% cap rate (what I have seen this past year).
A smaller multifamily property, let's call it 10 units, generally will only trade at around a 7% cap rate, although this might vary depending on the area. This discount is due to the following factors:
1). Increased tenant risk. With 200+ units, you have way more buffer regarding vacancy. If a couple tenants move out suddenly, given the size of the apartment complex you might not even dip into sub 90% occupancy. But with 10 units? If you have 1 or 2 tenants leave that's a huge dent on your top line.
2.) Property Management. Smaller multifamily properties lack the size that creates economies of scale. You can't hire a dedicated property manager for a 10 unit property, and even if you contract out to a third-party management company they will be taking a decent chunk out of your EGI, and you'll only be one property in what is likely a 10+ property portfolio. This is why most mom and pop landlords do most maintenance themselves, hiring workers on an as-needed basis for repairs.
3.) Financing. You don't get as attractive loan terms for smaller multifamily properties from lenders because they are generally viewed as a riskier asset. Sure there are exceptions, but this is generally the rule.
4.) Amenities. People expect amenities for most modern apartment buildings - even Class C multifamily in Florida almost always has a pool. It's hard to justify a pool and workout gym for 10 units, unless they are luxury, but you can make the numbers work for large properties. If given the choice to pick between a larger apartment complex with nice amenities and a smaller one without, big fucks small, always. That's how they command higher rents comparatively.
Respectfully disagree for the simple reason that private capital 1031 exchange money is the biggest buyer of sub $10MM CRE. I have seen multifamily properties in this price range trade for cap rates that made zero sense. i.e. on a 100% leased building in a market like Bev Hills, Santa Monica, etc trade for a 1.x% cap. No leverage, all cash, infinite hold period.
No "institution" would ever be able to compete, nor should they. Completely different set of motivations in this buyer pool.
Sure, but that's for an entirely different reason mate.
Those two Santa Monica landlords just swapped properties at stupid cap rates *with each other* in order to restart their 39 years depreciation and offset other income / gains. In another 39 years they'll swap with someone else at an even hire price and restart the depreciation.
No cash exchanged. No business plan to execute. Just a tax loop hole :)
Great post above. Also there’s a lower cost of capital once you get institutional
Disagree with the above. Many times, smaller assets actually trade just as low, if not lower, cap rates than institutional. It’s driven by two items. (1) dumb money. And (2) people not factoring in management costs etc and true opex because they will take care of R&M themselves. Therefore, not counting the true cost by a third party. This means you can pay more because NOI is higher. When you factor in running it properly - not doing it yourself - it becomes a 4% cap.
Not entirely true. I’d say smaller assets just trade at more unpredictable cap rates. There is a lot of dumb money out there. In 2020 I was seeing little 4-6 unit deals marketed for ~3-4% caps without mgmt costs or tax reassessments baked in, and some traded above ask (the broker feedback I always got was the buyer was always a rich guy outside of real estate i.e. a surgeon or tech guy who "wanted to park money in real estate" -- do these guys not realize they'd get better yield buying VNQ???). I also scooped one up in this time period for a ~6.5% cap from a clueless seller. Small cap space is kind of all over the place, whereas larger stuff is always tied pretty closely to prevailing cap rates since everybody is a pro doing the same underwriting and due dilligence and looking at the same comp set and getting the same debt quotes.
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