Understanding the Cap Rate for Multi-Family Properties
I’m a Multi-family Real Estate wealth creator with over 860 doors and 22MM AUM. Through my experience in this industry, I can show you the right path forward by sharing my knowledge, network, and expertise to get you started with your investing journey. In this blog, I’ll explain to you one of the crucial concepts used in evaluating Multi-family properties which is the Cap Rate.
Before investing in any multi-family deal, real estate investors want to know whether that deal is good or not. A good deal refers to an investment that generates strong returns and this is where the cap rate metric comes into play.
A cap rate is a tool that provides a more objective comparison of properties based exclusively on financial data like rents, expenses, and more.
So, let’s talk about the Cap Rate in detail.
What is the Capitalization Rate (CAP Rate)?
The calculation of the Cap Rate provides investors with insight into a deal’s assumed profitability. The Cap Rate is the ratio between the property’s net operating income (NOI) and the purchase price, as shown below.
Cap Rate = Net Operating Income (NOI) / Purchase Price
Usually, cap rates tend to fall between 3 to 10+ percent. However, actual cap rates can vary based on factors like property condition, location, and many others.
Understanding Net Operating Income
The formula to calculate NOI is as under:
NOI = Gross Income (GI) – Operating Expenses
Gross income refers to the total amount of real income that was collected from your property in the last 12 months, such as rent, laundry, parking, etc.
Operating expenses include the total amount of ongoing expenses you will incur from day-to-day operations on the property. It is significant to note that it excludes your debt payments and one-off expenses (CAPEX).
Cap rates are inversely proportional to property values. Thus, if cap rates are higher it will generally equate to lower values and vice versa. So, investors should expect to pay more for assets in a low cap rate environment than properties at a higher cap rate.
Multi-family Cap Rate
Multi-family Cap Rate is associated with risk. Properties with high Cap Rates are to be considered riskier than those with lower Cap Rates.
However, properties with lower cap rates usually take longer for investors to get back their initial investment. While properties with higher cap rates allow investors to get back their money faster from multi-family properties.
The difference between Cap Rate and Return On Investment (ROI)
Cap Rate and ROI are two separate terms that people often confuse as the same. Thus, it is important to get a clear understanding of both these terms.
The ROI includes debt service, unlike the cap rate. It is based on the amount of equity used to purchase the property rather than the entire purchase price.
ROI = Annual Return / Total Investment
So, let us see what is a good Cap Rate for Multi-Family properties.
A good cap rate for multi-family properties is quite subjective as it depends on certain factors like the local market, the quality of the building, etc.
Class A multi-family properties generally trade at a lower cap rate as compared to Class B or Class C apartment buildings.
Thus, a “good” cap rate for multi-family properties is at least 4% but can extend up to 8% and even 12%!
Conclusion
Multi-family properties usually tend to have a lower cap rate than other real estate investments, regardless of market or property condition. This is because apartments are attractive to investors of all kinds, therefore investors are often willing to pay a premium for multi-family assets than other property types.
If you’re interested in investing in commercial real estate but don’t feel comfortable with metrics like cap rate just yet, consider investing alongside a team of experts.