Capitalization Rates Explained | What is a Good Cap Rate?

May 15, 2020
May 15, 2020 disrupt

Introduction to Capitalization Rates 

In the multifamily real estate industry, our return on investment, assuming we purchase the asset in cash, is known as a capitalization rate, or most commonly known as the cap rate.

The capitalization rate is a metric that showcases how long it will take to get your money back from your initial investment.

In multifamily real estate many real estate syndicators would argue that the capitalization rate is just as important as the net operating income and even as important as the purchase price… in fact, that’s even how you calculate it!

 

Calculating Cap Rates

The cap rate is calculated by the net operating income (NOI) of an asset divided by its purchase price. 

For example, if the NOI is $600,000 and the purchase price of a multifamily complex is $10,000,000 then the capitalization rate is $600,000/$8,000,000 which equals 7.5%. 

Depending on your market a 7.5% capitalization rate could be good, but in other markets, it may be unrealistic.

When analyzing an investment opportunity, the capitalization rate is a crucial aspect of underwriting as it provides syndicators with a portion of insight into the future. 

For example, assume you’re analyzing a multifamily property with an 8% cap rate.

This capitalization rate shows syndicators that it would take around 12.5 years to receive the return on their investment at 8% every year assuming that they operate it the same way as the previous owner and do not put effort into forcing its appreciation and boosting it’s NOI. 

A property’s capitalization rate can deviate with fluctuations in an assets property value, NOI, etc and reminder that the capitalization rate assumes that you have purchased the cash in full with zero leverage

When you use leverage, then your ROI  typically comes quicker. 

Another key concept to remember is that multifamily assets are not like single-family rentals.

Single-family real estate is based upon the houses in the same neighborhood (comps) whereas apartments are valued based on their profitability with respect to their investment or in other words, the capitalization rate!

 

Comparing Cap Rates

An important analysis when looking at capitalization rates is knowing how to compare them.

Generally speaking, a lower capitalization rates such as 4-5% would be a class A or class B asset.

A medium cap rate (6% – 8%) would typically classify as a “B-” or “C” class property.

A high cap rate (8% +) are typically class “C” or “D” assets.

For a better understanding of asset classes check out our video here

This analysis can vary dramatically based on the market you are in. 

A 6% cap rate in New York City is a completely different property than a 6% cap rate in a more rural town with a lower population. 

A good rule of thumb for real estate investors is that higher populated cities have cap rate compression, in other words, they generally have lower capitalization rates on average.

In the same application for run-down areas may have a much higher capitalization rate for all asset classes.

 What is a Good Cap Rate?

Before analyzing what a good cap rate is, it’s vital that as a real estate investor, you know your investment criteria.

Understanding your investment criteria will allow you to know what deals you are looking for and how to utilize the capitalization rate to find the right deal for you and your investors.

To determine your personal investment criteria, you must ask yourself the following questions:

What returns are you looking for?

Do you prefer high monthly cash flow or a long-term appreciation of your asset?

Keep in mind that most assets with strong monthly cash flow do not appreciate too much overtime vice versa. 

What is considered a high capitalization rate for the area typically produces a large cash flow monthly but doesn’t appreciate much over its hold time.

Whereas a low capitalization rate typically doesn’t have high monthly cash flow but in most cases will have strong appreciation over time. 

A good example of this would be a mobile home park with a high capitalization rate. 

A mobile home park may produce high monthly cash flow but the appreciation overtime will not go up much. 

On the other hand, if you examine a low cap rate asset in New York City, the monthly cash flow may be much lower due to the higher expenses, but the asset would appreciate much higher overtime.

Hold time, appreciation, and cash flow are all criteria you need to think about as an investor, that way you can better understand what kind of cap rates you are looking for

 

Other Key Terms Relating to the Capitalization Rate

Now that we went over many aspects of the capitalization rate, there are some other key terminologies related to capitalization rates that you should be aware of as an investor or potential investor.

Recapitalizing – this refers to the capital restructuring debt and equity. This occurs in the hopes of making a company more stable. 

Cap Rate Compression – various factors that push the cap rate lower known as cap rate compression. Cap rate compression is typically an indicator of rising prices in the market.

Reversion Cap Rate – the projected capitalization rate at the time of sale at a future date, this helps real estate syndicators determine financial projections when acquiring the asset.

 

Re-Cap on the Capitalization Rate

The capitalization rate is a metric that shows investors how long it will take for them to get their money back from an investment.

To calculate a property’s cap rate you divide the NOI by the purchase price.

Cap rates will be altered based on fluctuations in these two aspects of an asset.

Understanding the basic principles of the capitalization rate, how to apply, and what it means to your specific investment criteria is vital to ensure that you’re investing in the right types of assets. 

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