The cap rate is important to understand when analyzing potential multifamily properties. But what is a good cap rate for multifamily properties?
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Real estate investors considering a multifamily deal will want to understand whether that deal is a “good deal” or not. By a good deal, they generally mean—will this property generate strong returns? This is where the cap rate metric comes into play.
This is because each investment opportunity is unique. Unlike buying shares of a tech stock where one Class A share is worth the same as another, no two real estate assets are exactly alike.
Two seemingly identical buildings built at the same time by the same developer will have small differences. For example, their exact locations will differ, as will their tenants and rent rolls. This can make it difficult to do side-by-side comparisons of properties, but you still always need to account for these differences.
Here is where the cap rate can be helpful for investors. Cap rates are a tool that provides a more objective comparison of properties based exclusively on financial data like rents, expenses, and more.
In this article:
The term “cap rate” is short for “capitalization rate.”
It is based on a quick calculation that provides investors insight into a deal’s assumed profitability. Cap rate is just the ratio between the property’s net operating income (NOI) and the sales price, as we’ll show below.
Cap rates tend to fall in the range of 3 to 10+ percent. Actual cap rates can vary based on the property type, location, property condition, and more.
Cap rates and property values have an inverse relationship.
Higher cap rates generally equate to lower values and vice versa. Investors should expect to pay more for assets in a low cap rate environment than properties at a higher cap rate.
Multifamily cap rates also tend to be correlated with risk.
Properties with high cap rates tend to be considered riskier (maybe due to a sub-par location or need for significant improvements) than those with lower cap rates. Newer, stabilized buildings generally have lower cap rates.
To that end, properties with lower cap rates usually take longer for investors to earn their initial investment back. Higher cap rates allow investors to earn their money back faster from multifamily properties.
Watch and learn more about the 4 key real estate metrics ⬇️
Cap rates are easy to calculate, which is why this metric appeals to investors of all skill levels.
The cap rate is the ratio between the net operating income and purchase price. It is a quick calculation used by anyone interested in investing in multifamily real estate.
Cap Rate = Net Operating Income (NOI) / Purchase Price
For example: a building with $650,000 per year in NOI purchased for $12,000,000 would have a 5.4% cap rate ( = $650,000 / $12 million).
Since cap rates are based on an income-to-price ratio, investors should understand what goes into the NOI calculation.
NOI is calculated by subtracting all operating expenses from gross income.
Gross income typically includes:
Operating expenses are considered any costs necessary to operate the property, including:
The remaining income after operating costs are subtracted, is the property’s NOI.
Gross Income – Operating Expenses = Net Operating Income (NOI)
You’ll see that neither capital expenditures nor debt payments are considered operating costs and, therefore, are not included in the NOI calculation. This is largely because CapEx and debt depend on the operator’s business plan.
For example, different buyers may want to:
Therefore, excluding these factors from the cap rate calculation allows investors to make a better side-by-side comparison based simply on in-place financial data assuming no debt on the property.
Let’s take an example of how a cap rate is commonly used. Suppose we are researching the recent sale of a multifamily rental property.
Here’s what we know about the property:
We would calculate this property is being sold at a 7.14% cap rate ($1m / $14m).
If you are a buy and hold investor, what is this cap rate telling you?
One way to think about a cap rate is that it represents the percentage return an investor would receive on an all-cash purchase. In the above example, an all-cash investment of $14,000,000 would produce an annual return on investment of 7.14%.
Another way investors use cap rates is to help determine a property’s value.
For example: Class B apartments in Sunshine City, USA, tend to trade around a 6% cap rate. The broker provides you with the financials. The property’s NOI is $430,000. What does this translate into for a property value?
Simply reverse the calculation to solve for the purchase price:
Purchase Price = NOI / Cap Rate
In this example, that translates into the following:
$430,000 / 6% = $7.17 million
Here’s why that’s useful 💡
An owner may be looking to sell that property for $9 million. A prospective buyer can come in and, using the cap rate calculation, show that the property is worth nearly $2 million less based on the area’s current cap rate environment. Being armed with data is generally more valuable when negotiating with the seller (vs. coming in and just saying, “I don’t think it’s worth that much”).
The seller may not budge on their sales price, but this is valuable information as someone compares their investment opportunities.
People often confuse cap rate and return on investment (ROI). Cap rate and ROI are two separate and distinct calculations.
Unlike the cap rate, the ROI calculation includes debt service. It is also based on the amount of equity used to purchase the property rather than the entire purchase price.
Therefore, the ROI calculation is as follows:
ROI = Annual Return / Total Investment
In this case, the annual return is the net operating income (NOI) less debt service.
Let’s use the following example:
Using the above, ROI would be $250,000 / $3,000,000 or 8.3%.
Neither cap rate nor ROI is better than the other. Instead, investors will generally use both of these calculations to analyze a real estate investment. ROI is simply another tool in the analytical toolbox that can be used alongside cap rate to better understand a deal’s profitability.
Determining a “good” cap rate for multifamily properties is rather subjective. It largely depends on the local market. For example, the average cap rate in high-demand areas like New York, Miami, and Los Angeles may be 4% or less.
The cap rate also depends on the quality of the building. Class A multifamily properties generally trade at a lower cap rate than Class B or Class C apartment buildings.
That said, a “good” cap rate for multifamily properties is at least 4% but can extend up to 8% to 12%.
Regardless of market or property condition, multifamily properties tend to have a lower cap rate than other real estate investments. This is because apartments are attractive to investors of all kinds, and therefore, investors are often willing to pay a premium for multifamily assets vs. other property types.
Several factors can impact a cap rate, including:
Let's dive into each 👇
Cap rates generally vary from one property type to another, even within the same geography.
For example: an investor might expect multifamily cap rates to be around 4-6% versus office cap rates which may be closer to 6-9%. Retail, hospitality, and industrial cap rates can also vary from market to market. In general, multifamily has historically had some of the lowest cap rates among all property types.
Older properties tend to have lower cap rates for several reasons.
The building might be physically deteriorating and/or have higher operational costs. Older properties may have features considered functionally obsolete. The building’s configuration or unit layout may make upgrading the property with more modern amenities difficult.
A property’s location has a major impact on its cap rate.
More desirable locations tend to have a higher market value, which leads to lower cap rates. In comparison, properties in secondary or tertiary markets tend to be worth less and, therefore, have higher cap rates. Investors will always want to understand the local market cap rate average.
Location within a specific metro area also impacts cap rates. Historically, urban properties trade at lower cap rates than either suburban or rural multifamily buildings.
The condition of a multifamily property will also impact its cap rate.
Properties in better physical condition, particularly those with in-demand amenities, will usually trade for lower cap rates than properties needing significant capital expenditures. Class A properties generally tend to have lower cap rates than Class B or C apartment buildings.
Related to the above, amenities can influence a property’s cap rate.
For example: an apartment building with covered parking, a high-tech fitness studio, a pool, a co-working space, storage lockers, and a dog wash station will generally command a premium compared to buildings without these amenities.
Investors must recognize the influence of local competition.
This could be existing competition (already built assets), projects in the pipeline (i.e., those already permitted and/or under construction), and the potential for new competition based on low land values and a supportive regulatory environment (i.e., low barriers to entry).
For example: an existing asset may have a going-in cap rate of 5%. However, if a developer builds a similarly-sized apartment building in the same vicinity, this may cause the cap rate to rise on the older asset. The owner of the older asset may need to make value-add improvements to remain competitive in that marketplace—and these improvements will certainly come at a cost.
Market conditions and other economic trends also impact cap rates. For example, interest rates and cap rates tend to be correlated. As interest rates rise, this impacts an investor’s purchasing power. Therefore, as interest rates rise, so do cap rates.
Economic trends can also impact cap rates. For example, the COVID pandemic ushered in a new wave of hybrid and remote work, making office space less desirable. As a result, cap rates for office space have risen.
There are several different cap rates investors use to assess multifamily investments, including
It’s critical to understand these differences as a going-in cap rate can be substantially different from the one-year out cap rate or exit cap rate if the owner has substantially improved and/or raised rents during their hold period. Changes to market conditions, such as rising interest rates, can also impact the going-in, one-year-out, and exit cap rate spreads.
Cap rates are undeniably one of the most widely used investment metrics. They provide a useful, quick comparison of investment opportunities. Any investor will want to use a cap rate as they analyze real estate investments, whether looking at a multifamily investment property or other property types.
To maximize the value of this metric, look closely at what’s driving the cap rate and whether there is room to improve cap rates over time (some things, like location, can never be controlled. Other factors, like market conditions, are out of an investor’s control).
As always, investors will want to use cap rates alongside other analytical metrics like ROI. Other investment metrics should also be considered, like internal rate of return and cash-on-cash return.
If you’re interested in investing in commercial real estate but don’t feel comfortable with metrics like cap rate just yet, consider investing alongside a team of experts. Learn more about HoneyBricks today.