What Is A Good Cap Rate For Multifamily Real Estate Property?

If you are thinking of investing in a multifamily property, understanding the importance of cap rate when evaluating a potential acquisition is absolutely critical to your success. Knowing the capitalization rate of real estate can help you manage investment risks and avoid high-risk, low-return investments. 

What is a Cap Rate in Real Estate? 

A cap rate or capitalization rate is a key metric that real estate investors use to analyze and objectively compare potential investments. It is used by multifamily real estate investors to indicate the expected return on their investment in real estate. This rate is determined by taking the property’s expected net income and dividing it by the specific property’s asset value and is expressed as a percentage. An investor uses the multifamily cap rates to determine their potential ROI before investing capital in a property. 

The cap rate in real estate is influenced by the building’s quality as well. Typically, Class A multifamily properties command a lower cap rate compared to Class B or Class C apartment buildings. A desirable cap rate for multifamily properties falls within the range of at least 4%, but it can stretch to 8% to 12%. 

Irrespective of market conditions or property quality, multifamily properties generally exhibit a lower cap rate compared to other real estate investments. This is because apartments hold significant appeal for investors across the board, leading them to often pay a premium for multifamily assets over other property types. 

Cap Rate Formula 

Wondering what is a good cap rate for rental property? Here’s the formula that can help you figure this out: 

Cap Rate = (Income – Expenses) / Cost 

Simply put, gross income minus operating expenses, divided by the purchase price is the capitalization rate for a specific real estate. 

Cap Rate Example 

Consider an example demonstrating the typical application of a cap rate. Let’s say we are looking at the recent transaction of a multifamily rental property. 

Here are the property details we have: 

Purchase price: $14,000,000  

Gross rental income: $1,250,000  

Operating costs: $250,000  

Net operating income: $1,000,000  

From this information, we deduce that the property is being sold at a 7.14% cap rate (calculated as NOI of $1 million divided by the purchase price of $14 million). 

What does this cap rate mean? 

It represents how much money you would make each year if you bought the property with all cash. In the example, if you spent $14,000,000 without taking a loan, you would earn a yearly return of 7.14%. 

Cap Rate vs. Return on Investment (ROI) 

Cap rate and return on investment (ROI) are frequently mistaken for one another, yet they involve distinct and separate calculations. 

Contrary to the cap rate, ROI calculation incorporates debt service and relies on the equity invested in the property rather than the total purchase price. 

Hence, the ROI calculation is expressed as: 

ROI = Annual Return / Total Investment 

Here, the annual return represents the net operating income (NOI) minus debt service. 

Consider the following example: 

Purchase Price: $10,000,000 Down Payment (Equity): $3,000,000 Net Operating Income: $400,000 Debt Service: $150,000 Annual Return: $250,000 

With the given data, the ROI would be $250,000 / $3,000,000, resulting in 8.3%. 

Neither cap rate nor ROI holds superiority over the other. Investors typically use both metrics to evaluate a real estate investment. ROI serves as an additional analytical tool alongside cap rate, aiding in a deeper comprehension of a deal’s profitability. 

Advantages of Determining a Multifamily Property’s Cap Rate 

The following are three major advantages of knowing a property’s capitalization rate: 

Risk Analysis: The Cap rate is responsible for determining the ideal risk/reward ratio. Potential ROI is more significant at higher cap rates, but so are the risks. Lower cap rates are less risky, but not a wise investment. 

Calculating Potential Return on Investment: Ultimately, the most important advantage of cap rates is that they allow you to estimate your best-in-class financial return based on the information available. 

Investment Review: When evaluating multifamily investment potential, the multifamily cap rate can be used as a benchmark metric to compare different properties. 

What is a Good Cap Rate for a Multifamily? 

A good cap rate for multifamily is anywhere over 4% and under 10%, depending on where you are in the market cycle, geographic location, property condition, and the balance of supply and demand of rental units in a particular region. A higher cap should usually be expected in areas with low demand for rental properties. Having said that, know that each situation is different. Cap rates are important, but they should be seen as part of the bigger picture, not as the sole indicator of an investment’s likely success or failure. 

Which Factors Influence Multifamily Cap Rates? 

Following are some of the crucial factors that influence the capitalization rate of multifamily real estate: 

Property market 

A look at the designated markets and current available inventory allows investors to better understand their potential position in the market and better understand the risk-reward equations of multifamily investment. 

Location 

Location has a huge impact on cap rates for multifamily real estate. Properties closer to employment, entertainment, and lifestyle options can demand higher rents due to higher resident attraction. Properties within such bustling areas have a reduced investment risk as they experience high demand and constant cash flow. 

Asset Vintage 

Properties are divided into three categories based on their age. For example, Class A is less than 10 years old, while Class C is 30+ years old. Older properties typically have higher maintenance costs and can cost a lot in a given year thus increasing costs and lowering the cap rates. 

Rate of employment 

Multifamily cap rates also depend upon the current employment rate. Positive employment data in the market is highly correlated with cap rate compression, which can be a positive feature. This could be an indication that prices are rising and that some investors see real estate investments in this area as less risky compared to other investment options. 

Income 

High household incomes generally result in a lower cap rate. After all, the creditworthiness of residents, landlords, and buyers reduces the risk in a market. 

Assessing Different Cap Rates 

Investors utilize several cap rates to evaluate multifamily investments effectively. 

These include: 

1. The going-in cap rate represents the current rate based on historical NOI. 
2. The one-year-out cap rate is derived from the projected NOI. 
3. The exit cap rate is particularly significant when aligning with a sponsor’s business plan, relying on their forecasts regarding refinance or sale prospects. 

Understanding these distinctions is crucial because a going-in cap rate may differ significantly from the one-year-out or exit cap rate, especially if the owner has substantially increased rents during their hold period. Additionally, shifts in market conditions, such as fluctuations in interest rates, can influence the disparities among going-in, one-year-out, and exit cap rates. 

BFPM Can Help You Invest 

Cap rates are crucial when you are thinking about investing. They are like a quick way to compare different investment options, especially in real estate. Whether you are checking out apartments or other types of properties, cap rates help you decide. 

To make cap rates work best for you, look at what is making them high or low. See if you can make more money from the property over time. But remember a few things, like the market trends, that you can’t change. 

While many would like to access assets with different risk/reward profiles and shorter return periods, entry points seem to be out of reach for some. BFPM provides a convenient way to invest in multifamily homes; our experts know how to study the dynamic real estate market before making recommendations. Feel free to book a quick 15-minute consultation call if you want to know how we can help you optimize your property and maximize your profits.