Cap Rate: The Number with a Story
If you and another investor buy similar multifamily properties, they both generate $1000 in revenue/ month, would you both make the same net profit? Not necessarily, it depends on your financing, or the payment terms under which you purchased your multifamily investment, and the resulting mortgage payment.
Financing real estate can be done in many ways with varying interest rates, loan durations, loan-to-value ratios and the list goes on. Depending on the terms of your financing your monthly mortgage payment could be $0 or >$1000. Imagine your mortgage payment is $100 but the other investor's payment is $500.
You're making $900/ month while he/she is only making $500. If such similar deals can generate vastly different profits, how do you compare them objectively? The short answer is a Capitalization rate, more often referred to as a "Cap Rate".
What is a cap rate in real estate?
So what exactly is a cap rate and why is it so important? Cap rates attempt to equalize all investments by removing the variable of financing. It assumes purchases are made all cash so all investors have the same mortgage payment - a whopping $0.
Once expenses are paid, there is no additional mortgage payment. All that is left is the net operating income (NOI) that the property generates. NOI is the Net Total income - total expenses. NOI is how much profit your multifamily apartment community makes before mortgage payments are accounted for.
The Cap rate formula is Cap Rate = Net Operating Income (NOI)/ Purchase price.
"Example: If you purchase a property for $10,000 and the NOI is $1000 the cap rate is .10 or 10%
10% cap rate = $1,000 NOI/ $10,000 purchase price "
This ratio reveals a percentage return of your net income relative to cash invested. Since you purchase is all cash, your cash investment amount is equal to your purchase price. So the higher the cap rate percentage, the higher the return you're making, the better the investment, right? Well, not necessarily. Now that you understand *what is a cap rate and how is it calculated*, let’s get to the origin story.
The Cap Rate Origin Story
Cap rates are not set in stone. Depending on which set of financial records you use to determine NOI, the associated cap rates can assess and compare the past, present and future performance of a property to itself or to similar assets in a local market.
Commonly investors use the last 12 months of financial data, the last 3 months annualized or a combination of income and expense data for different periods annualized or mixed with pro forma projections. The first thing you should ask yourself when looking at a property level cap rate is “what financial data is the NOI based on?” Depending on what records were used, the associated cap rate may be realistic or unachievable
“The first thing you should ask yourself when looking at a property level cap rate is what financial data is the NOI based on”
What cap rates should you know for every deal?
The cap rate of the property based on its current financials alone does not tell you if the property will make a great return. For many reasons such as poor management or maintenance, the cap rate based on current financials may be higher or lower than what the property will perform at once you take ownership. When assessing a multifamily property you would like to purchase or invest in, there are a few types of cap rates you want to be aware of.
Market cap rate is the prevailing cap rate multifamily apartment communities of similar risk / return profiles trade at in a submarket. This is a number you get from comparable sales. Knowing the cap rate can give you a quick idea of the value of your property if you were to sell. Revisiting the cap rate formula you know that NOI = $1,000 and your market cap rate is .10, it is reasonable to assume the purchase/sale price would be equal to NOI/cap rate or around $10,000.
Going-in Cap rate refers to the cap rate achieved during the first year after a property is acquired. This is based on Pro-Forma projected income and expenses but can be compared to actual financial data you collect during your first year. You may compare this to the market cap rate to decide if you are getting a good deal.
“Stabilized cap rate is the cap rate the property produces once you have achieved your set business plan, and have maintained property occupancy at a level >90% for at least 90 days."
Stabilized cap rate is the cap rate the property produces once you have achieved your set business plan, and have maintained property occupancy at a level >90% for at least 90 days. For a textbook value add program, this would be the cap rate of the property once you have completed renovations and achieved rent premiums.
How long this takes depends on how distress the property was on acquisition and how high demand is in the submarket. The financial data used here may be based on data annualized from the last 90 days of stabilization. Typically the better the stabilized cap rate and the faster you can achieve it, the better the deal.
Reversion/Exit cap rate is the anticipated cap rate at sale. Conservatively this would be projected relative to the market cap rate at purchase. For example, a cumulative ratio-based increase for each year of ownership such as .10 bps /year from acquisition until anticipated sale.
All of these cap rates should be considered together when analyzing a real estate investment. Looking at only one paints an incomplete picture. For instance, if you’re wondering What should your "going-in" cap rate be? The answer may be irrelevant viewed in isolation. It should be reviewed alongside your stabilized cap rate, how much room there is for growth and how long it would take to reach that stabilized cap rate.
What are the benefits of a low cap rate market?
In a low cap rate market, there is low perceived risk. It is considered a stable market because investors have historically been able to achieve consistent returns and the trend is expected to continue. If the market cap rate is low doesn’t that mean the return will also be low? If we refer back to the cap rate formula we can see that the lower the cap rate is the greater the impact of any increase in NOI. Take a look at these three multifamily properties that all had a $100 increase in their NOI.
So as you can see, the same increase in net income creates more value the lower the market cap rate is. As you can imagine, low cap rate markets get expensive quickly creating a higher barrier to entry. There is also a lower cash flow. However, that may be somewhat offset by the increased value/ equity created.
Is a higher cap rate better?
Higher cap rate markets are often seen as risky but for experienced investors with local knowledge they make profitable investments. In these markets, while it is possible to make great returns, it may require more hands on work and micromanagement.
You will also need to increase the income of the property by a greater amount to see significant increase in value on sale. Values in these markets tend to increase slowly but investors are able to offset this with higher cashflow.
What is a good cap rate?
Now that you understand cap rates don’t live in isolation, your next question might be - what is a good cap rate? It ultimately depends on your risk tolerance, your desired level of involvement in the investment, your experience level and your investment goals.
Incredible returns have been made in all cap rate environments. Remember, cap rates are based on an all cash purchase. So if you are using appropriate financing, your yield will be much higher than your cap rate.
“What is a good cap rate? It ultimately depends on you”
*Cap Rate vs Yield* - what's the difference?
Yield is similar to cap rate in that it flatly tells you a percentage return on an investment, however it does not necessarily remove the financing variable. When talking about yield it is more precise to clarify if financing is included (levered) or not included (unlevered). These are just two of several metrics you should be aware.
Cap Rates Summarize a Story
Cap Rates are a lot like camp stories. Did you ever go camping as a child? Or maybe as an adult with your own kids? After you finished roasting your marshmallows you and your family or friends probably gathered around the campfire to tell spooky stories. Somehow, the dim natural light of the fire and the intermittent crackling sound of the firewood enhanced every detail, making it so much more engaging.
“Cap rates … they are a numeric summary”
Change the scenario, you're inside, in a brightly lit room filled with sterile artificial light, telling the same story. Would it be as spooky? or mysterious? Chances are not. What does this have to do with cap rates and real estate investing? Well, cap rates tell a story that can green-light an investment or send you running for the hills. In fact, they are a numeric summary and as a savvy investor it's your job to find out their back stories, and bring them into the light.