As a real estate investor, you need to understand all the metrics and formulas that help you make smart decisions. One of the most important tools in real estate is the capitalization rate, or cap rate. It’s a key metric that helps you figure out potential returns on a property while weighing the risk. For multifamily investors, getting a good cap rate can be the difference between a good investment and a bad one. Let’s get into what cap rates are, how they’re calculated and what’s a good cap rate for multifamily.
Cap Rates
Cap Rate Definition
The capitalization rate, or cap rate, is a metric real estate investors use to measure potential return on an income producing property, like a multifamily building. It’s a percentage and represents the annual return an investor can expect to get on a property based on its net operating income (NOI) and current market value or purchase price.
A cap rate gives an investor a snapshot of the investment’s risk and reward. A high cap rate may mean higher return but more risk. A low cap rate may mean a safer investment but smaller return.
How to Calculate Cap Rates
The formula is simple:
Cap Rate = (Net Operating Income) / (Purchase Price or Fair Market Value)
For example, let’s say you have a multifamily property that produces $500,000 in net operating income (NOI) and the market value or purchase price of the property is $5,000,000.
The cap rate would be:
Cap Rate = $500,000 / $5,000,000 = 0.10 or 10%
So the property has a 10% cap rate, 10% return based on current numbers.
What Affects Multifamily Cap Rates
Several things affect cap rates for multifamily properties, let’s get into them.
Market and Location
Location is one of the biggest factors that impact cap rates. Properties in prime locations—near employment centers, public transportation, shopping, entertainment and lifestyle amenities—can command higher rents. So properties in those areas tend to have lower cap rates because they’re considered lower risk, stable investments. For example, multifamily properties in Tier I cities (New York, London, San Francisco) have lower cap rates because of higher property values, strong demand and lower vacancy rates.
On the other hand, properties in less desirable locations, like rural areas or weaker economic markets, have higher cap rates. While these properties may look like a higher return on paper, they come with more risk, higher vacancy rates or lower rental income potential.
Property Characteristics
Multifamily properties are classified by age and condition, which affects their cap rates. Properties are typically categorized into three classes:
Class A: These properties are less than 10 years old, in excellent condition and in prime locations. Because they’re newer and require less maintenance, Class A properties have lower cap rates.
Class B: These buildings are 10-20 years old and in good condition but may need some updates. Class B properties have higher cap rates than Class A because of their age and potential for higher maintenance costs.
Class C: 30 years or older, Class C properties need significant updates or repairs. These properties come with more risk and operating costs, higher cap rates.
The condition of the property also matters. Properties in good condition will have lower cap rates, properties with deferred maintenance or structural issues will have higher cap rates to compensate for the added risk.
Economic Indicators
Interest rates and broader economic factors like employment rates and GDP growth also impact cap rates. When interest rates are high, cap rates go up as borrowing costs increase and the net return on investment decreases. When interest rates are low, cap rates go down as borrowing is cheaper and investors will accept lower returns for stability.
Economic downturns or distress can cause cap rates to go up as the perceived risk of owning multifamily properties increases. During strong economic growth cap rates can go down as the perceived risk is lower and demand for rental properties is higher.
Investment Opportunities
Cap Rates
A “good” cap rate for a multifamily property depends on the location, property condition and market conditions. Generally cap rates for multifamily properties range from 4-10%. Properties with cap rates in the lower end (4-5%) are in prime markets with lower risk, properties with cap rates in the higher end (7-10%) are in secondary or tertiary markets or require more hands on management and repairs.
When looking at cap rates don’t view them in a vacuum. Investors should consider the exit cap rate which is the cap rate at the time of sale. Changes in the going out cap rate can have a big impact on the return on investment so understanding how market conditions will impact this is key.
Property Analysis
Cap rates are a useful tool for comparing properties. But they should be just one part of the overall investment analysis. Investors should also consider the risk/reward ratio and how the cap rate fits into their overall investment strategy.
For example a property with a high cap rate might look attractive because of the higher returns but it could come with higher risk such as higher vacancy rates or repairs. A property with a low cap rate might offer stability and lower risk but limit the investor’s ability to make big money.
Cap Rates
Going-In vs. Going-Out Cap Rates
Real estate investors refer to two types of cap rates: going-in cap rate and going-out cap rate. Going-in cap rate is the cap rate at the time of purchase, going-out cap rate is the cap rate at the time of sale.
Forecasting the going out cap rate is important because it can have a big impact on the overall return on investment. A small change in the going out cap rate can have a big impact on the sale price and ultimately the investor’s profit. So investors should be conservative when projecting future cap rates and take into account market shifts and economic conditions.
Historical Multifamily Cap Rates
Looking at historical cap rates for multifamily properties can be helpful when evaluating current investment opportunities. As of October 2023 the average cap rate for multifamily properties across public REITs was 5.8% which was up half a point from earlier in the year. The increase in cap rates was due in part to rising interest rates and changing market conditions.
By looking at historical cap rates investors can see how the economy, interest rates and market sentiment have impacted multifamily investments over time. This can be especially helpful when making long term investment decisions or deciding when to buy or sell.
Conclusion
Cap rates are a key metric for real estate investors especially when it comes to multifamily properties. Knowing how cap rates are calculated, what impacts them and how to read them in the bigger picture will help investors make better decisions.
A “good” cap rate will vary depending on location, property condition and market conditions but investors should look for the right balance between risk and reward. By doing so they can win in the real estate game.
Cap rates are a powerful tool but use them with other metrics and analysis to fully evaluate any multifamily investment.