When investing in multifamily properties, you’ll need to first understand how to measure common real estate financials to properly conduct research into properties.
What Is Cap Rate?
Cap rate (or capitalization rate) is a key metric used to by investors to analyze real estate investments by comparing its cap rate to similar properties. It’s the most commonly used metric for evaluating the risk and ROI involved in a real estate investment and allows investors to quickly compare similar properties to find good investments or to determine if their current investments are being mismanaged.
How to Calculate Cap Rate for Multi-Unit Properties
Multifamily cap rate is simple to measure. You’ll first need to determine the net operating income (NOI) of a multifamily property by subtracting all operating expenses from the overall gross income of the building.
Net Operating Income (NOI) = Gross Income – Operating Expenses
Once you determine a property’s NOI, you’re ready to calculate cap rate by taking NOI and dividing it by the multifamily investment’s purchasing price or current market value.
Cap Rate = Net Operating Income (NOI) / Purchase Price
Let’s look at an example.
You are considering purchasing a new multifamily property, Park Place Apartments. The listing price is $900,000. By looking at financial records, you see that the gross income from its residents the previous year was $100,000 and the operating costs were $25,000.
We first need to calculate net operating income:
Now that we’ve determined that the NOI of Park Place Apartments is $75,000, we’re ready to calculate its cap rate. We do that by taking the NOI and dividing it by the purchasing price or current value of a multi-unit property:
That’s it! The cap rate of the hypothetical Park Place Apartments is 8.3%.
Why Cap Rate Is Important to Multifamily Investors
Cap rate helps investors determine the overall value and profitability of both specific investments and broader markets and neighborhoods. Specifically, the three main benefits of calculating a multifamily property’s cap rate are:
- Risk Level – A lower cap rate has less risk but also may not be a worthwhile investment. A higher cap rate means higher potential ROI but also a higher risk. It is up to investors to determine the sweet spot that balances risk and reward.
- Analyzing & Screening Potential Investments – Real estate investors use cap rate as the baseline metric when comparing multiple properties against each other and are one of the first steps when investigating new investments in multifamily properties
- Calculating ROI – At the end of the day, the main benefit of cap rates are projecting a return-on-investment to the best of your ability using the data available to you.
What Is a Good Cap Rate for Multifamily Investments?
Multifamily properties have one of the lowest average cap rates of any property asset type due to its lower risk. Overall, a good cap rate for multifamily investments is around 4% – 10%. However it’s not quite as simple as that.
Cap rate is only a useful metric when comparing similar investments. For real estate investors comparing cap rates, you’ll need to take three major factors into consideration: asset type, asset class, and location.
Asset Type & Cap Rate
Cap rates vary depending on the property being evaluated. This is because of the level of perceived risk among different asset types. Multifamily properties have the lowest average cap rates among real estate investment types due to a lower financial risk.
According to CBRE’s recent cap-rate survey for North American properties, the average cap rate for multifamily properties ranges from 5.20% to 5.49% depending on location.
Asset Class & Cap Rate
Asset class helps better compare properties of similar value to one another based upon the overall integrity and age of a property. A general breakdown of asset classes for multifamily properties are:
- Class A – Less than 10 years old
- Class B – 10-20 years old
- Class C – 20-30 years old
- Class D – 30+ years old
Newly constructed properties come with less risk and higher property value. Therefor Class A multifamily properties have the lowest cap rates.
While age is the only factor that can impact asset class (think about renovations and different asset degradation), age is the simplest way to grade investments when comparing cap rates.
Location & Cap Rate
For real estate investors looking to broaden their portfolio with new multifamily investments, determining what a good cap rate is for their market is crucial. Luckily for you, CBRE releases a bi-annual cap-rate survey that ranks the best markets for multifamily investments.
CBRE uses a tier system to group and rank markets against one another using cap rate as the ranking metric. Here is the CBRE data on the average cap rate for multifamily properties in its three highest tiers:
- Tier I Average Cap Rate – 3.75 – 4.75%: These markets are the largest cities and urban areas in the US, along with their surrounding metropolitan area. This includes the Bay Area, Boston, Chicago, Los Angeles, New York City, San Diego, Seattle, Southern Florida, and Washington D.C.
- Tier II Average Cap Rate – 4.00 – 5.25%: These markets are high-growth urban areas on the cusp of tier 1 markets including Atlanta, Austin, Dallas, Houston, Minneapolis, Nashville, Orlando, Philadelphia, Phoenix, Portland, Sacramento, and Tampa.
- Tier III Average Cap Rate – 4.50 – 7.00%: These markets are smaller, yet still economically strong cities including Cincinnati, Columbus, Indianapolis, Jacksonville, Kansas City, Milwaukee, Oklahoma city, Pittsburgh, Salt Lake City, and St. Louis.
Why do higher tier’s have lower cap rates? Larger metropolitan areas have higher property values, higher populations, and lower vacancy rates, all factors to multifamily investments having lower risk.
This news piece is from 2ndkitchen.com and was published May 21, 2020
