Experts predict a hot multi-family market for 2022, which means investors need to be able to compare multi-family properties and decide which ones represent the best opportunities for profit. That’s where capitalization rates, cap rates for short, come into play.
What is Cap Rate and Why Is It Important?
Cap rate is one metric used in real estate investing to estimate the potential return on investment (ROI) from a given property, which provides a basis for comparing prospective investments. When used for this purpose, cap rate is calculated as the ratio between the property’s net operating income and the capital cost to acquire it.
Cap rate also is used to determine whether a currently held property is meeting ROI projections and performing as well as anticipated. When this is the intent, cap rate is the ratio between the net operating income from the property and the property’s current value.
Cap rate is essentially a measure of risk—specifically the risk that a particular property won’t be as profitable as anticipated. Generally, the lower the cap rate, the less risk there is, but also the lower the ROI potential. The reverse is also the case; a high cap rate means higher risk but also the potential for a higher ROI. For investors in multi-family properties, cap rate can be a helpful tool for identifying properties that offer the right balance of risk and reward and for determining whether operating expenses are cutting into the profitability of current holdings. That being said, cap rate is only one benchmark and is best considered in conjunction with other metrics.
How is Cap Rate Calculated for Multi-Family Properties?
To calculate the cap rate for a multi-family property you’re thinking about buying, you’ll need to determine its current market value, annual operating income, and annual operating expenses. There are several paid services that provide property valuations, but some are more accurate than others when it comes to multi-family properties. Alternatively, you can ask a broker or appraiser in the area for an estimate of the property’s current market value.
Annual operating income is the total of all income generated by the property, from rents collected from tenants to the quarters they feed the washing machines and dryers in the laundry room. If you don’t have access to that information, perhaps the listing broker can provide it. Otherwise, you’ll need to estimate it based on what you can learn about the property and/or comparable properties in the area.
The third piece of information you’ll need is the annual operating expenses, excluding mortgage payments. If that information isn’t readily available, you’ll need to come up with an estimate that includes taxes, insurance, management fees, and any other costs associated with ownership and management of the property.
Subtracting annual operating expenses from annual operating income gives you the annual netl operating income (NOI), which is the factor used in the calculation.
Calculating cap rate is the easy part. The hard part is coming up with the numbers that go into the calculation. Once you have the net annual income, simply divide it by the current asset value, and the result is the property’s cap rate: net operating income ÷ current asset value x 100 = cap rate.
Here’s a simple example for a multi-family property:
- Net annual income = $62,000
- Current asset value = $1 million
Cap rate = $62,000$1,000,000 = .062 x 100 = 6.2%.
The result is expressed as a percentage for easy comparison.
Comparing Cap Rates
Comparing cap rates won’t enable you to make an educated decision about a potential purchase unless all the properties you’re comparing are of the same asset type, in the same asset class, and in the same general location. So, to continue with our example, you would need to be comparing that property’s 6.2% cap rate to the cap rates of other assets of the same type: multi-family properties.
Multi-family properties are classified according to their age, finishes, location, and amenities:
- Class A: Properties less than 10 years old – The nicest apartments in the nicest areas with the nicest amenities
- Class B: Properties from 10 to 20 years old
- Class C: Properties from 20 to 30 years old
- Class D: Properties 30 years old or more – a lot of deferred maintenance in the worst areas
Multi-family properties typically have lower cap rates than other asset types, such as office, industrial, retail, and hotel properties because there is less risk of disappointing financials. And newer multi-family properties are less risky than older ones, so the cap rates for Class A properties are lower than the cap rates of properties in Class B, C, or D.
Comparing the cap rates of multi-family properties in different locations can be misleading because of the differences in demand and per-unit rents. A downtown property in a bustling city and a similar property on the outskirts of town or in a neighboring suburb may have very dissimilar cap rates. And what is considered a good cap rate in one location may be considered a warning sign of unacceptable risk in another. The more you know about a particular location and the factors affecting demand and rent levels, the better able you will be to use cap rates effectively to compare and evaluate potential investment properties. This is why it’s best to have an expert on your side! You can reach out to me at any time for questions and more information.
What’s a Good Cap Rate for Multi-family Investment Properties?
Many investors rely on CBRE’s cap rate survey that assigns different markets to cap rate tiers according to the average cap rate in those markets. The survey is repeated every two years. The chart below illustrates the three highest cap rate tiers. Tier I markets, with the lowest average cap rates, are the least risky for multi-family investments because of higher property values, greater housing demand, and lower vacancy rates.
|Tier||Average Cap Rate||Market Description||Markets|
|I||3.75 – 4.75%||Largest cities and surrounding metropolitan areas||Boston, Chicago, Los Angeles, New York City, San Diego, San Francisco Bay Area, Seattle, South Florida, Washington, D.C.|
|II||4.00 – 5.25%||High-growth urban areas||Atlanta, Austin, Houston, Minneapolis, Nashville, Philadelphia, Phoenix, Portland, Sacramento, Tampa|
|III||4.50 – 7.00%||Smaller markets with strong economies||Cincinnati, Columbus, Indianapolis, Jacksonville, Kansas City, Milwaukee, Oklahoma City, Pittsburgh, Salt Lake City, St. Louis|
The main thing that distinguishes the various cap rate tiers is location and the relative ease or difficulty of achieving a good ROI, which is another way of looking at risk. Consider the contrast between a neighborhood in a Tier I market where the demand for rental housing is high, vacancy rates are low, and property values are high and one in a Tier III market where the demand for rental housing may be high and vacancy rates low, but property values and household incomes are also lower.
The Tier III market has, at least on paper, more potential for a high ROI, but also a higher risk of not attaining that ROI for any number of reasons. Rents are lower, and tenant turnover can be higher, with periods of vacancy that erode annual rental income. Collecting rents may not be as easy as in a more affluent neighborhood.
The lower cap rate in the more affluent neighborhood indicates a lower ROI but also a lower risk of anything getting in the way of achieving it. Tenants are less likely to be late paying the rent or to break a lease, making it easier to achieve the expected return. It’s also easier in such cases to exceed the projected ROI by making upgrades that tenants are willing to accept a rent increase for, such as providing internet, adding on-site laundry facilities, expanding parking, or similar improvements.
What Can a Current Investment’s Cap Rate Tell You?
As noted earlier, cap rate is a metric not only for comparing multi-family properties as potential investments but also for evaluating a current investment property’s profitability compared to the investor’s original ROI expectations. Calculating the cap rate at some point in time after purchasing a multi-family property and comparing it to the ROI that was projected for the investment can reveal the need to make some changes that either increase revenues from the property or decrease operating expenses. One caution here, though: this may not be an accurate reflection of the return potential of a property that was purchased at a time when property values were much lower.
How Reliable Are Cap Rates?
Cap rates are helpful as benchmarks indicating a general value range but should not be regarded as a reliable measure of a property’s true value over time. For one thing, a cap rate provides a snapshot at a certain point in time, using data for a 12-month period. Conditions 12 months down the road or a few years into the future may be completely different. There’s also a common tendency to be overly optimistic, especially when excited about the possibilities envisioned regarding a particular property. One big mistake with multi-family properties is assuming full occupancy at all times. A cap rate based on a zero-vacancy assumption is likely to be misleading. Any number of things can occur in the near future that can affect a property’s market value and the income it produces.
If you think of cap rates as serving the same purpose as Kelley’s Blue Book serves in the valuation of used vehicles, they can be very useful. They are a great starting point, but they don’t tell the whole story, and what they fail to account for can make a big difference in the outcome.