“What’s the cap rate?”
This is a question that’s commonly asked in the multifamily space, particularly when an investor is vetting a deal. Cap rates are an important, but often misunderstood aspect of any multifamily deal.
So what is a cap rate? And why do they even matter?
Let’s delve into it.
Cap Rate Defined
A cap rate measures the average cost of capital needed to buy a multifamily property. Multifamily investors use the cap rate to determine how much they should pay for any particular multifamily property.
How Is The Cap Rate Calculated?
Let me provide some quick context before we calculate the cap rate of an example deal.
When an investor buys a multifamily property, they usually get most of the capital from a lender and the rest from investors. Typically, the debt to equity ratio is 70/30. But for the sake of the example below, let’s assume that an investor named Adam is buying a multifamily property with all cash.
Also: The Net Operating Income of a property is the actual or expected net income after operating expenses are deducted from effective gross income.
Now for the example.
Let’s say Adam the investor is looking to purchase an apartment complex with a purchase price of 10,000,000. Let’s say the Net Operating Income at the property is $500,000,000.
As a reminder:
Purchase Price = $10,000,000
NOI = $500,000
So, to calculate the cap rate:
NOI / Purchase Price = Cap Rate
$500,000 / $10,000,000 = 5% Cap Rate
What Does This Mean?
A cap rate of 5% means that the property will generate a 5% return on Adam’s investment.
So it isn’t that difficult to calculate a cap rate for a property. It’s just plugging in numbers into a simple equation.
Why Do Cap Rates Matter?
Cap rates really only matter if you’re looking to buy or sell a property. If cap rates compress or decompress during the hold period of an asset, but you’re not planning on selling anytime soon, then they don’t have any significant impact on your business plan or the property’s performance.
But let’s say you buy a property. What would happen if when it comes around time to exit, you find that interest rates have changed drastically? Cap rates would also change as a result.
A sudden increase in interest rates could result in cap rates to increase. Assuming the property’s net operating income remains the same, this would mean that the property would decrease in value.
Remember:
NOI / Purchase Price = Cap Rate
So if interest rates increase, buyers have to pay more for the property due to more expensive debt. With an increased cost of borrowing, and no change in the net operating income, the cap rate is expected to rise. This means that sellers can expect to see properties lose value if cap rates increase.
Multifamily Properties Valuation
Multifamily properties are valued differently than single family properties. Single family houses are valued based on comparable properties. These “comps” are nearby properties that have recently sold in the area, and are used to determine how much the subject property will go for on the market.
Meanwhile, multifamily properties are valued based on how much of a return they provide an investor relative to the purchase price. This metric is known as the cap rate.
Benefits of Identifying a Property’s Cap Rate
Measures Risk: Investors need to know how much risk is involved in a deal relative to the return they could potentially make. Oftentimes, a lower cap rate is associated with a higher valuation and stronger likelihood of meeting returns, meaning less risk. Meanwhile, a higher cap rate suggests lower likelihood of return on the investment, meaning there’s more risk.
Vetting the Deal: Cap rates allow an investor to standard of measurement to compare multiple different investment options.
Return Potential: Cap rates ultimately allow investors to calculate what they can expect to make on their investment. Investing is all about making money on your money, afterall.
How To Analyze Cap Rates
Cap rates allow investors to estimate a property’s worth. The higher the cap rate, the riskier the investment, but also the greater the potential return.
Understanding how to compare cap rates is an essential skill for multifamily investing.
As explained in this Forbes article:
Low Cap Rate (3-5%): Typically associated with nicer areas, superior amenities, low crime, good school system, newer builds, and A-B class properties.
Medium Cap Rate (5.5-8%): Lower income area, moderate level amenities, medium crime rates, average schools, older builds, B-C class properties.
High Cap Rate (8% or more): Low income area, little to no amenities, high crime, bad schools, outdated construction, usually C-D class properties.
Cap Rates: A History
The submarket and specific asset class of a property can impact cap rates. But cap rates also tend to fluctuate over time. How much change they undergo depends on the economy and the commercial real estate market as a whole.
Source: Carlos Vas.
Historically, cap rates have increased as interest rates have risen and during recessions. In 2008, as seen in the chart above, cap rates shot up by about 3%. When people lost their homes, many of them looked to multifamily for housing, which drove up demand for multifamily.
What Is a “Good Cap Rate” For an Apartment Complex?
Multifamily cap rates are usually lower than the cap rates of asset classes such as industrial, retail, and office. Although these other asset classes might generate more revenue, they also involve more risk.
Since multifamily properties offer less risk, they have lower cap rates than any other property asset class.
According to Honey Bricks, a good cap rate for a multifamily deal is “at least 4% but can extend up to 8% to 12%.”
It’s important to note that if you want to compare cap rates, the assets should be similar to provide any meaningful comparison of their values.
Conclusion
Cap rates are important for multifamily investors, especially in times when interest rates are rising and economic uncertainty is the only certainty. Therefore, it’s important for investors, both active and passive, to understand the implications of a cap rate and how it fits into the greater picture of any particular investment opportunity.