The capitalization rate, also known as the cap rate, measures the profitability and return potential of the multifamily property by factoring in both the asset’s market price and net operating income. The cap rate represents the yield of a property over one year, assuming the property is purchased in cash and not on loan. It is expressed as a percentage.
The cap rate is obtained by dividing the property’s net operating income by its market value.
Cap rate = Net Operating Income/Market Value
Net Operating Income is obtained by deducting the operating expenses from gross income. Gross income includes rental income and income from additional services like laundry, parking, etc. Operating expenses are the cost involved with the operational activities of the property, like property taxes, insurance, repair and maintenance charges, management fees, etc.
Operating expenses do not take debt expenses into account. This limits Cap Rate’s focus on market and asset performance without considering the financing of the property.
Location: High-growth markets in desirable locations and high-demand areas have low cap rates, while less desirable locations have high cap rates.
Asset Type: With increasing risk from Class A to Class D properties, cap rates also increase. Stabilized and newer properties, that is Class A properties have lower cap rates than Class B and C properties.
Economic Conditions: High interest rates make borrowing costlier, which reduces the market value of the property, thus, increasing the cap rate. However, this relationship is not direct as other factors like supply and demand dynamics, and market conditions also affect property valuation.
A good cap rate is subjective and highly influenced by the markets, property types, and investors’ specific goals and risk tolerance. A good cap rate at one location might not be a good cap rate at another.
Cap rates are inversely proportional to the property value. A multifamily property with a high valuation will have a low cap rate. High valuation occurs when the location is favorable and the property is stabilized, thus making a low-risk investment. However, with a high valuation, there is less wriggle room for the property to appreciate and increase in value further. Thus, even though low cap rates involve low risk, they also provide lower returns.
Conversely, undervalued properties offer greater returns on investment, as they are acquired at low prices and provide high monthly rental income. However, they also make for risky investments.
By analyzing the market’s cap rate and comparing it against the property to be acquired, you can better assess the profitability potential of the investment. For example, in a market with an 8% cap rate, acquiring a Class A stabilized property is a steal deal; however, a Class C property at the same cap rate will not make a lucrative deal.
In general, high cap rates offer high returns but also involve high risk. While low cap rates involve low risk, it also means a more extended period to recover the investment. Thus, there is a trade-off between property returns and risk factors involved.
If you have high-risk tolerance in exchange for high returns, properties with high cap rates will align with your investment goals. When looking for a less risky passive income, choose low cap rates.
A good cap rate also depends on what investment stage you are evaluating the property.
Going-in Cap Rate: It is the cap rate of a property in the first 12 months of acquisition. When looking at the cap rate at the buying stage, you may look for a high cap rate to get more returns while investing less.
Exit Cap Rate: The cap rate of the acquired property at the end of the holding period is the exit cap rate. A low exit cap rate makes a good cap rate, as it means a high selling price, that is you make more profit on the sale or refinance.
Thus, investment is profitable when Exit Cap Rate is lower than the Going-in Cap Rate. This phenomenon where cap rates decrease over time is known as Cap Rate Compression and is observed in markets experiencing strong demand and growing economic conditions. Cap rate compression greatly benefits property owners.
Even though cap rates are a key metric when evaluating the profitability potential of an investment, it is not without certain limitations. Cap rates do not take into account property appreciation, monthly debt paid on the property, market potential, and other variable factors.
As the cap rate considers only the current market value and is a variable factor in multifamily underwriting, it should be used with other factors such as location, property condition, potential for rental growth, market conditions, etc.
Cap rates should always be viewed in the context of the surrounding conditions. If the cap rate of a property is low compared to the market cap rates, it could mean either it is overvalued or its net income is low. This low cap rate presents a value-add opportunity where the net operating income can be improved with renovations and other value-add strategies. However, you should decide on the strategy after considering the full picture of the market and property conditions. You should ensure thorough due diligence to find the right investment opportunity.
Summing up, Cap Rates alone do not provide a complete profitability assessment of the property. However, understanding the cap rate of the property and comparing it with surrounding market conditions along with analyzing it against your investment goals, can help you get a clear analysis of the profitability potential of the investment, thus narrowing down your options.