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What Is a Good Cap Rate For Multifamily? 5 Things You Need to Know

Cap Rate in Real Estate Explained

If you’re looking at investing in a real estate syndication, you have likely come across the term cap rate real estate. The cap rate (short for capitalization rate) is the return on investment, assuming you purchased the property in cash. This metric is valuable for investors because it shows them how long it will take to recuperate their initial investment. Naturally, higher cap rates mean investors will get their money back quicker, while lower cap rates mean a more extended period.

The capitalization rate is an essential piece of the deal. 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! This metric guides how much a property is worth and, ultimately, whether or not you should invest in it or not.

The question for investors is: what is a good cap rate in real estate? And to go even further, what is a good cap rate for multifamily real estate properties? Here are five things you need to know about the cap rate so you can know whether or not your prospective investment is worth it or not!

Cap Rate Real Estate: How to Calculate This Metric

Before getting into the discussion about what makes a good cap rate, it’s worth first reviewing how to calculate this metric!

Fortunately, the way to calculate this metric is relatively trivial. The cap rate is calculated you need to divide an asset’s net operating income (NOI) by its purchase price.

The formula is:

Cap Rate for Real Estate = (Income – Expenses) / Purchase Price

 

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

Or, as another example, if you’re buying a property that has $1 million in income, $500,000 in expenses, and costs $20,000,000 to buy, its cap rate is a mere 2.5% ($1,000,000 – $500,000 = $500,000 / $20 million = 0.025 * 100% = 2.5%).

As noted in the introduction, cap rates are a way to describe how long it will take to get your original investment money back. Once you calculate the cap rate, you can divide 100 by that to get the years.

So, in our examples above, if you’re getting 7.5% back per year, that means you’ll get your original investment back in about 13 years. On the other hand, investing in the other project at 2.5% will take a whopping 40 years to get your money back!

What is a Good Cap Rate For Multifamily Properties?

Now that you know how to calculate the cap rate, you’re probably wondering how to tell if a cap rate is reasonable or not and what a good cap rate is for multifamily! Intuitively, investing in something that will take 40 years to get your money back feels problematic, but is 13 years good, or can you do better?

While there are many regional variations, generally speaking, lower capitalization rates such as 4-5% would be a class A or class B asset.

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

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

For a better understanding of multifamily real estate asset classes check out our video here-Multifamily Real Estate Asset Classes

If you check out the video of the asset classes, you’ll see that properties with higher cap rates typically have more risk. That makes sense – more risk means more reward potential.

However, there are also regional variations for cap rates. A cap rate of 6% will be for a different property in NYC than in a rural town. For real estate investors, a good rule of thumb is that higher populated cities have cap rate compression. In other words, they generally have lower capitalization rates on average.

Bottom line: What is a good cap rate for multifamily? There is no singular “good cap rate real estate” to answer that question. Instead, many factors at play, including your appetite for risk and location, determine whether or not a cap rate is reasonable.

5 Things to Consider When Looking at Cap Rates

With all that said, the number is not the only aspect of a cap rate that you need to consider when making a deal. Here are five things you need to know and keep in mind about this metric.

1) Cap Rates Are Not Guaranteed and May Appreciate or Decline

A cap rate is only a snapshot of the present. Recall that you’re taking current income and current expenses, but there’s nothing in the formula that considers new renovations, different management, marketing differences, and so forth. These can make a cap rate higher or lower as the investment term progresses.

Consider a multifamily purchase that has a mediocre cap rate of 4%. But, perhaps market research shows that a few renovations will significantly boost the net operating income to the point where the cap rate is an excellent 10%.

2) Investment Cap Rates Vary from Deal to Deal and Market to Market

Consider that cap rates will vary dramatically between deal to deal and market to market. The average capitalization rate in San Francisco is a mere 2.7%. By contrast, the average rate in Dallas for a suburban multifamily property is 5.75%.

Therefore, if you want a deal that will make above inflation, San Francisco is not the market to do that. Dallas, and many other cities across the United States, will give you a rate above inflation. But most deals in San Francisco just won’t. If you’re not finding the terms you like in one city, it may be time to consider investments elsewhere!

3) Don’t Lose Sight of Appreciation

Cap rate does not take appreciation into account. Multifamily properties can (and do) appreciate. This affects the determining factor of what makes a good cap rate in multifamily. To give you an example, why is the cap rate in San Francisco so low? The underlying land is so valuable that, historically, there’s been quite a bit of appreciation potential, even if the ROI is low.

However, with that said, appreciation is theoretical and may not happen depending on how the market goes. The rent and net operating income you earn are likely more predictable than the market. Remember that the building’s income is not the only way to make money in real estate!

4) Be Mindful of Leverage

Please remember that the cap rate assumes that you have the cash in full with zero leverage. When you use leverage, your ROI typically comes quicker.

Consider the following example. Let’s suppose you have $50,000. You invest in one project with a cap rate of 6%. Or, you can use leverage and borrow $50,000 from the bank at 2% interest. Then, if you invest in two projects at a 6% rate, each at $50,000, you’ll be earning 12% off your original $50,000 (6% off each investment) but only paying out 2% in interest.

Therefore, if you have leverage, you can improve your returns, even when investing in projects that have safer, more mediocre cap rates.

5) A Multifamily Property’s Valuation Is Unlike a Single-Family Home

If you are used to investing in single-family homes, you likely know that single-family home valuations come from comps. An appraiser will come out, look at the property, and determine how much it is worth based on the sales prices of other similar properties.

Multifamily and commercial properties derive much of their valuation from their cap rate. A multifamily property that doesn’t make much money will not be as valuable as one that does, assuming the same property type. Put another way, if the Waldorf Astoria generates $1 million a year, it might be worth $10 million. But if it generated $100 million a year, it might be worth $1 billion! Nobody will spend $1 billion to make $1 million a year, but they absolutely will to make $100 million.

Cap Rates and Your Investment Criteria

As you can likely already tell, cap rates are just one aspect of a deal. They’re fundamental and vitally important, but they are only one aspect.

Another aspect you’ll want to consider is your investment criteria and goals. 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 seeking?
  • Do you prefer high monthly cash flow or a long-term appreciation of your asset? Or, another way to put this is: when will you need your original investment money back?

Keep in mind that most assets with a solid monthly cash flow do not appreciate too much over time and vice versa. Indeed, a high capitalization rate for the area typically produces a large cash flow monthly but doesn’t appreciate much over time.

On the flip side, a low capitalization rate typically doesn’t have a high monthly cash flow. However, it will have a strong appreciation over time in most cases. As we already discussed, this is partly why San Francisco investments have such a low cap rate!

Therefore, consider not just the cap rate but also hold time, appreciation, and cash flow. These are all valid criteria to think about as an investor. Once you understand this, you’ll better understand what type of capitalization rate you want and need.

Other Key Terms Relating to the Capitalization Rate

There are some other terms relating to cap rate real estate that you should know. If you’re looking at deals, you’ll probably come across one or more of these terms concerning cap rates!

Recapitalizing – this refers to the capital restructuring debt and equity. Companies trigger this process in the hopes of making it more stable.

Cap Rate Compression – various factors that push the cap rate lower are known as cap rate compression. Cap rate compression is typically an indicator of rising prices in the market. Recall that lower cap rates typically indicate higher appreciation potential!

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

Cap Rate Real Estate: Very Important but Not the Sole Metric!

The capitalization rate is a metric that shows investors how long it will take to get their money back from an investment. To calculate a property’s cap rate, divide the NOI by the purchase price.

As a quick reminder, the formula is:

Cap Rate = (Income – Expenses) / Purchase Price

These are the only aspects of the purchase that calculate the cap rate. However, income and price should not be the only factors you consider when entering a deal.

Indeed, a lower cap rate often indicates higher appreciation potential and safer investment. Inversely, a higher cap rate shows more risk and less appreciation.

Therefore, what cap rate you look for depends on what type of investment you want. If you’re looking for more risk and higher revenue potential, you might want a higher cap rate. If you want something safer, a lower rate is indicative of that. As an allegory, a 20% junk bond is no better or worse than a 2% T-bill. They both have their use and which one you pick depends mainly on your investment goals! What is a good cap rate for multifamily? One that aligns with your goals and provides an adequate reward for the risk!

 

We hope this article provided you with clarity on cap rates and what a good cap rate is in multifamily real estate! If you are interested in investing in multifamily real estate syndications, please visit Disrupt Equity’s investment page here. On this page you can go through our investors Frequently Asked Questions as well as submit a form to be notified of our upcoming investment opportunities!

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