The Private Buyers Get It. The Institutions Will. Your Window is Now.

There’s an interesting dynamic in parts of the Bay Area today: institutional deals are trading at higher cap rates and lower prices per unit than private capital deals. I’d argue that’s often the case in most places all of the time, but the spread seems particularly wide right now. We saw this last year, and it’s the reason we bought a three-property portfolio that we intend to sell off individually to private buyers. So far on that deal, our rents are $300–500 above pro forma for two-bedroom units, and we even hit $1,000/month over pro forma on a renovated three-bedroom—a rent level we hadn’t even contemplated in our initial underwriting. Rents are growing quickly, as are our eyes toward an exit.

Private capital will see this real rental momentum and largely ignore the in-place negative leverage, because they’ll believe it’s only temporary. Achieving high rents across multiple units and unit types lends further credence to the business plan. Even better if that private capital is in a 1031 exchange. Those buyers desperately need a replacement property and will pay top dollar—though they’ll also blow out of your deal if they find something better. Regardless, the private capital market is playing with a different set of assumptions today.

Institutional capital, on the other hand, is padding expenses, projecting rent growth off paid sources (RealPage, CoStar, YardiMatrix), and pushing for positive leverage on day one. When all the potential buyers on a deal think this way, the eventual pricing reflects it. This is what’s led to the wildly different cap rates and per-unit metrics we’ve seen between institutional and private capital deals.

If you’re lucky enough to buy one of these lower-priced institutional deals, and it’s too big for a private capital exit, can you bank on a lower cap rate from another institution? Maybe.

That “maybe” rests on one bet: that if interest rates fall and rent growth continues to accelerate, institutional capital will have no choice but to get more aggressive and more closely resemble the underwriting of a private buyer. Otherwise they won’t win deals. Capital won’t sit on the sidelines as revenue and NOI grow.

The big difference between the two buyers is how they operate. Private capital will either self-manage or hire a local property management company. They won’t carry much overhead, will likely run a thin operating budget, and may split resources with another property. The institutional investor, whether they hire a third party or not, carries a higher expense load and will try to budget for everything. What’s a 6-cap for the private buyer is a 5-cap for the institution.

I’d rather underwrite the full litany of what could go wrong than run a thin budget and undercapitalize a deal. So would every investor. And it’s great when you can do that and still win the deal. But when you can’t, investors do strange things to win. They underwrite rents that haven’t been achieved in the market. They assume certain expenses don’t apply to their ownership. They convince themselves they can pay their staff less. In an upwardly accelerating market, these underwriting sins are forgiven: NOI grows in spite of rising expenses, cap rates decline, and hold periods get much shorter. The next buyer has to deal with it.

When the future is unknown, you can’t assume major improvements in cap rates if your buyer views the world the way you do. That’s the challenge today: knowing what your exit looks like. It’s fair to assume some level of cap rate compression, especially if you believe new Fed Chair Warsh has a mandate from President Trump to lower interest rates. How much to assume is anyone’s guess—though I doubt this buyer pool is programming in much. The exception is San Francisco, where rents have gone vertical. It’s now #1 on everybody’s list, and if you want to play, you have to pay up—which means assuming significant compression just to win the deal.

It’s a unique time to be able to buy assets at normal cap rates, with positive leverage, in markets with growing rents (or rents about to grow). This is for vintage assets only: older product, not the new(ish) construction that’s still trading at negative leverage, even in markets like Austin where rents are declining. Those buyers are hoping for major rent growth and NOI improvement, since cap rates won’t have the same impact. The larger vintage deals have a more limited buyer pool, and that’s where pricing is best today. Even if they never trade as thin as their smaller counterparts do to private capital, there’s considerable room to profit as rents rise and interest rates fall in line with the Administration’s expectations.