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What is a Good Cap Rate for Multifamily investing?

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Identifying a Good Cap Rate

The cap rate is important to understand when analyzing any real estate investment. But what is a good cap rate for multifamily investing?

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Real estate investors considering a multifamily need to understand whats a “good deal” or “bad deal”. By a good deal, that generally means — will this property generate attractive, risk-adjusted returns compared to other investments opportunities?

This is where the ‘cap-rate’ metric comes into play.

Every investment opportunity is unique and 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 different valuations. For example, while their locations may be almost the same, their tenants profiles, rent performance and expense management could lead to wide variances in value. This can make it difficult to do side-by-side comparisons of properties, but you still always need to account for these differences.

Cap rates are a tool that provides a more objective comparison of properties based exclusively on financial data.

In this article:

 

What is the Capitalization Rate (Cap Rate)? 

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. The Cap rate is calculated as the ratio between the property’s net operating income (NOI) and the purchase price.

Cap rates tend to fall in the range of 3% to 10% depending on the asset, market dynamics and capital markets. For example:

  • In 2020 – early 2022, interest rates in the US were near 0%, lower cap rates were the norm as the asset owners could attract more capital and more effectively borrow from lower rates
  • From late 2022 – 2023 as interest rates started rising, this lead to less attractive debt packages in commercial real estate and need for higher returns to attract capital.

Cap rates vs. property values

Cap rates and property values have an inverse relationship. Higher cap rates generally equate to lower values and vice versa.

For example – if we take a multifamily investment with Net Operating Income of $1m, we can see the difference in valuation by applying different cap rates.

  • At a 4% cap rate, the building is valued at $25,000,000
  • At a 6% cap rate, the building is valued at $17,000,000
  • At a 8% cap rate, the building is valued at $12,000,000

Multifamily cap rates

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.

For example, cap rates for Multifamily buildings in New York city are almost always low single digits – as there is significant demand and low risk given the economic depth of city.

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 investments.

 

Cap Rate Calculation

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.

 

Cap Rate = Net Operating Income (NOI) / Purchase Price
For example: a building with $650,000 per year in NOI purchased for $12 million would have a 5.4% cap rate ( = $650,000 / $12 million).

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Understanding Net Operating Income (NOI)

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:

  • All rent payments
  • Ancillary cash flow like parking, storage lockers, and laundry

Operating expenses are considered any costs necessary to operate the property, including:

  • Property taxes
  • Insurance
  • Utilities
  • Management fees
  • Standard repairs and maintenance

The remaining income after operating costs are subtracted, is the property’s Net Operating Income (NOI).

 

 

NOI = Gross Income – Operating Expenses

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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:

  • Buy the property with cash
  • Use significant leverage
  • Make significant property improvements
  • Operate the property as-is

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. 

Cap Rate Example

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:

  • Purchase price: $14,000,000
  • Gross rental income: $1,250,000
  • Operating costs: $250,000
  • Net operating income: $1,000,000

We would calculate this property is being sold at a 7.14% cap rate (NOI of $1m / Purchase price of $14m).

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%. 

Using Cap Rate to Determine Property Value

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. 

 

Cap Rate vs. Return on Investment (ROI) 

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:

  • Purchase Price: $10,000,000
  • Down Payment (Equity): $3,000,000
  • Net Operating Income: $400,000
  • Debt Service: $150,000
  • Annual Return: $250,000

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.

 

Cap Rates vs. Treasury Bills

There is a implicit relationship between cap rates and Treasury bills, as both are indicators of the current economic climate.

Treasury bills are considered the safest and lowest-risk investment, and their yields are often used as a benchmark for other types of investments. Other investments need to compensate investors for the additional risk they are taking versus the risk free rate (i.e. Treasury Bills).

When Treasury bill yields are low, investors normally seek higher returns through riskier investments, such as multifamily real estate. This can lead to a decrease in cap rates, as more investors are willing to pay higher prices for real estate assets in order to achieve higher returns.

Conversely, when Treasury bill yields are high, investors may be less willing to take on risk and may instead favor safe investments like Treasury bills. This can lead to an increase in cap rates, as demand for real estate assets may decrease and investors may require higher returns to justify the risk.

Fluctuations in Treasury bill yields especially can are an important consideration for investors when analyzing potential deals as can have cause big changes in their impact on valuations.

Marcus & Millichap’s research on this shows the average cap rates for commercial real estate to the 10-year Treasury bond rate from 1990 to 2021.

What is a Good Cap Rate for Multifamily Investments?

Determining a “good” cap rate for different multifamily properties is rather subjective and heavily influenced by the economic cycle and 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.

By observing the movements in relative cap rates, Moody’s Analytics Structured Finance group’s CMBS data provided insights into the market trends. The average cap rate spread for secondary markets was 100-200 basis points higher for the first part of the past decade. Since then, the spread has narrowed to less than 100 basis points for all markets.

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. 

What Factors Can Affect the Cap Rate for Multifamily investing?

Several factors can impact a cap rate, including:

Let’s dive into each  👇

 

Property Type

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.

 

Property Age

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.

 

Property Location

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.

 

Property Condition

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.

 

Building Amenities

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.

 

Local Competition

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. 

 

Current Market Conditions

As outlined above and probably the biggest influence on cap rates is market conditions. For example, investor sentiment and confidence, as well as the interest rate environment are a significant driver to buyers chasing deals.

Assessing different Cap Rates

There are several different cap rates investors use to assess multifamily investments.

The bottom line for real estate investors

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 NOI over time while also being aware that other factors, like market conditions, are out of an investor’s control.  

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 EliteFinanx Today

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