For a real estate investor evaluating a multifamily investment, it’s crucial to understand what constitutes a “good deal” or a “bad deal.” A good deal generally implies whether the property can yield attractive, risk-adjusted returns compared to alternative investment opportunities. In multifamily real estate investments, the capitalization rate, commonly known as the “cap rate,” becomes a critical factor for buyers.
Real estate investors use the cap rate metric to evaluate multifamily deals and determine if the property aligns with their purchase criteria and desired overall return profile. Judah Feld, the VP of Acquisitions at Viking Capital, explains that cap rates provide a measure of risk and a tool for comparing properties.
“Essentially, the cap rate is the ratio of Net Operating Income (NOI) to purchase price. A higher cap rate indicates a higher yield, which means taking on increased risk. On the other hand, lower-risk properties offer safety and attract higher pricing for the same cash flow. Therefore, cap rates demonstrate the pre-debt service cash flow a property produces relative to its market value.”
In this article, we explain how the cap rate is used to compare Multifamily properties based on financial data.
Multifamily Cap Rates
When using a cap rate to assess the total value of a multifamily property and compare it to other properties in the submarket, three variables play a significant role in shaping an investor’s decision:
- Risk: A higher cap rate indicates higher risk, while a lower cap rate indicates lower risk. (We will cover high and low parameters later in this article.)
- Potential ROI: Gives the capacity to estimate a financial return.
- Terminal Cap Rate Comparison: A terminal cap rate (exit cap rate) estimates the cap rate for the property at the time of refinance or sale, based on the timeline outlined in the contract. The exit cap creates a baseline against other investment properties in the same area.
Understanding Cap Rates
This metric offers valuable insights into the future performance of an investment property. However, it’s essential to keep in mind that these predictions could be influenced by economic cycles, changes in net operating income (NOI), property value, as well as other market variables.
How to Calculate a Cap Rate:
Take the asset’s net operating income (NOI) and divide it by its value. This ratio, expressed as a percentage, serves as an estimate of an investor’s potential return.
In the above example, suppose this was an all-cash purchase of $10,000,000. This cap rate would produce an annual return on investment of 8% to its buyer.
Assessing the Cap Rate:
Cap rates vary significantly depending on various factors, including property class, location, age, market conditions, local comparables, and amenities. When questioned about the influence of these factors while assessing a deal, Chris Parrinello, Director of Investor Relations at Viking Capital, explained,
“While cap rates are significant, they are only one part of the story. When building a case for acquisition, you must also consider the current market cap rates in the area you are researching and predict where they will be at exit. Additionally, combining other metrics like price per door, replacement cost, and debt cost is crucial. As an investor, it is essential to keep in mind that proforma projections for rents and expenses are essentially estimates and often represent the best-case scenario. Therefore, it is vital to dig into the assumptions and ensure that you agree with whether they are conservative or aggressive. This due diligence is a must before making any significant investment decisions.”
Determining Optimal Cap Rates: High vs. Low
High
Generally, a high cap rate signals the potential for higher returns it may also have the potential lower prospects for appreciation, adding an element of risk. While a high cap rate in a specific location can yield substantial monthly cash flow, it may not necessarily translate to long-term appreciation. An example of a high cap rate cited by Forbes is investing in a trailer park. Although it will generate substantial monthly cash flow, the value of the investment is unlikely to appreciate over time.
Low
Conversely, a low cap rate typically demonstrates lower potential return but comes with reduced risk. Properties with lower cap rates are often more stable and established, commonly situated in prime markets with high demand and low vacancy rates. This stability generally leads to a steady income stream and the possibility of property appreciation over time. In the same Forbes article, Beverly Hills is cited as an example of a low cap rate, with the statement, “This area will not yield significant cash flow due to very high expenses; however, it is expected to appreciate many times over.”
Understanding this difference helps investors decide if this property suits their specific investment needs. Investors have different motivations, timelines, and desired return profiles, all of which can vary based on the cap rate and asset class of the property.
Here is a typical breakdown of cap rates:
- Low Cap Rate: (3%–5.5%)
- Medium Cap Rate: (5.5%–8%)
- High Cap Rate: (8% or higher)
Distinguishing between different cap rates is crucial in real estate investment:
- Going-In Cap Rate: Reflects the current rate based on historical Net Operating Income (NOI).
- One-Year Out Cap Rate: Anticipates the rate in the future, considering projected NOI.
- Exit Cap Rate: Vital for investment strategies, grounded in expectations about a refinance or sale.
As mentioned above by Mr. Parrinello, understanding these distinctions is imperative. A going-in cap rate may significantly differ from the one-year out or exit cap rate, particularly if the owner has made substantial improvements or increased rents during their holding period. Market changes, such as rising interest rates, can also impact these cap rate spreads.
Other related terms of importance:
- Cap rate compression: This refers to a situation where the cap rate, which is a measure of return on investment, is pushed lower due to various geographical, economic, and market factors. This usually indicates that prices in the market are increasing and there is a potentially lower risk perception for that asset class.
- Recapitalizing a deal: This is a process of restructuring a company’s capital mix of debt and equity, which is generally carried out to make the company more stable.
The Takeaway for Investors
Ultimately, cap rates are dynamic, evolving with each market, asset type, and location. Both high and low cap rates have their advantages and disadvantages, and considering these factors is crucial when evaluating a deal. It’s imperative to acknowledge that no two assets are identical, and various factors within the property can significantly influence the overall return profile and financial metrics. The cap rate provides investors with a comprehensive assessment of the property’s risk level and a potential benchmark for comparison against similar deals within the same market.
