What is Cap Rate?

Cap rate—or capitalization rate to give it its full measure—is a calculation used in real-estate investing to quantify the investment potential of an individual property, collection of properties, or trends across a specific market or region.

Team Invest Nest strives to bring as much genuinely useful content for real estate investors so it makes sense that we are discussing cap rates here today to help you determine whether or not a potential deal is a good one.

You as the investor will need to consider a broad set of factors when evaluating real-estate opportunities, including a property’s income stream, tenant mix, occupancy rates, and local market fundamentals. Cap rate offers a metric for assessing the perceived risk factor for a given property or area.

The simple formula (see below) involves calculating a property’s net operating income (NOI)— derived by subtracting expenses from the property’s income stream—and dividing this by the market value, or cost, of the property. Multiplied by 100, the cap rate is expressed as a

percentage value.

Higher cap rates represent greater investment potential but also greater risk; lower cap rates indicate lower risk but also potentially less reward. Taken along with other factors, this number can help investors decide where to park their money.

Taking a simple example to express the above formula, the cap rate for a multifamily housing unit with a market value of $1.5 million would look as follows, assuming annual expenses of $50,000 to manage the property and expected income of $150,000:

(150,000 - 50,000) / 1,500,000 = 0.067 * 100 Cap Rate = 6.67%

What is a Good Cap Rate for Multifamily Investments?

There is no single number that equates to a “good” cap rate, as it will be driven by numerous factors including shifting occupancy rates and interest rates, for example, as well as the individual investor’s financial strategy and appetite for risk.

Different markets and property types drive differing cap rates based on location (i.e. urban vs. suburban) and building type (i.e. Class A building stock vs. older Class C units). You as the

investor will need to take a critical look at your own preferences, resources, and strategy to determine whether or not the cap rate on an investment property is ideal for you.

CBRE’s North America Cap Rate Survey H2 2019 shows us average cap rates of just over 5 percent for multifamily real estate across all metro types; the average cap rate drops to 4.6 percent for Class A buildings compared to 5.7 percent for Class C property, reflecting the lower risk assumed by newer, higher-grade buildings that are likely to see a steadier occupancy rate and higher demand from prospective renters.

Source: North America Cap Rate Survey H2 2019, CBRE

Likewise, cap rates can be averaged across markets to help investors understand how their properties might be performing compared to the benchmark as well as identify potential areas for opportunity. The chart below from CBRE’s biannual report shows us how cap rates compare for Class A properties across the major metro markets in the United States. Lower cap rates in cities like Austin, Boston, or Seattle, for example, reflect traditionally reliable real-estate markets bolstered by limited supply and strong demand from renters in markets with strong employment and economic fundamentals.

Source: North America Cap Rate Survey H2 2019, CBRE

How Do I Factor Cap Rate Into My Real-Estate Investing Portfolio?

Let’s imagine you and your partners are interested in investing in a small multifamily opportunity in, say, downtown Chattanooga, Tennessee. You’ve researched the area and have started working with a local broker to identify suitable developments, who has now come back to you with two potential options.

The first property is a newer ten-unit construction located right in the downtown area, fully occupied and not in need of any significant repairs or upgrades. The sales price is listed at $1,000,000. Here are the numbers you and your team will need:

• ●  total monthly rent ($800/unit) = $8,000

• ●  monthly operating expenses (property management fee) = $4,000

• ●  net operating income per month = $4,000

• ●  net operating income per year ($4,000 x 12 months) = $48,000

• ●  cap rate = 4.8% (48,000 ÷ 1,000,000)

  Property number two, listed at $800,000, is located outside the downtown area in the slightly more industrial Orchard Village neighborhood. Rents and prices are lower here and the 15-unit Class B building is older and in need of a few repairs and unit upgrades. Its occupancy rate is only currently at 80 percent, or 12 out of the 15 units. Orchard Village is, however, thought to be an up-and-coming neighborhood and is popular with students attending the nearby University of Tennessee at Chattanooga. This property’s investment numbers look as follows:

• ●  total monthly rent ($700/unit at 80% occupancy) = $8,400

• ●  monthly operating expenses (property management fee) = $5,000

• ●  net operating income per month = $3,400

• ●  net operating income per year ($3,400 x 12 months) = $40,800

• ●  cap rate = 5.1% (40,800 ÷ 800,000)

  As you can see from the above thought experiment, the differing cap rates offer a method to weigh the opportunity and risk relative to your two target properties. The 15-unit property offers a slightly lower income yield as it currently stands, but is one that could be bolstered by investing in some upgrades to the individual units in order to ensure better occupancy rates as well as future rent increases. However, of course, the downtown development is a lower-risk bet based on cap rate as well as the knowledge that this newer construction is in a desirable location plus has existing high demand from renters.

  Now it’s up to you and your savvy investor friends to take what you have learned here and use it as a filter to help you sort out which investment properties are a proper match for you and your team.

  If you have any questions about cap rates or possible deals then drop a comment and a member of our awesome community here at Invest Nest just might be able to offer some guidance.