An understanding of capitalization rate, often referred to as “cap rate”, is essential for any property investor. Calculating the cap rate of a property before you buy it is a great way to ensure you choose a project with the potential for an excellent return on investment (ROI).
What is Cap Rate?
Cap rate is a measure used by investors and lenders to assess the profitability of a property. Cap rate offers important insight to all parties involved with buying, investing in, borrowing against, and selling real estate.
What Does Cap Rate Mean for You, as an Investor?
Investors use cap rate to help them determine the value of multifamily apartment buildings (and other properties) prior to acquisition. In fact, both investors and lenders use this measure to determine the project’s value, so it’s a great way to gain insight ahead of meeting with your lender to discuss your loan.
Factors that Determine Cap Rate
Multifamily apartments located in rural areas will usually have a higher cap rate than those in downtown metropolitan areas that are very desirable with plenty of demand. This is due to the fact that owners of desirable, city-center properties can often charge residents more in rent, and have a higher Net Operating Income (NOI). Metropolitan cities that have little land for newly constructed supply have lower cap rates as well.
The asset class of the property, age, and condition can also affect cap rate. A Class A property that is newly or recently constructed, located in a popular and safe neighborhood that is in high demand will also have a lower cap rate than a Class B or C property will have. Class B and C properties are older and may have outdated amenities, leading to reduced rental rates compared to their Class A competitors.
How to Calculate Cap Rate
The capitalization rate of a property is determined by dividing the Net Operating Income (NOI) by its current market value.
Cap Rate Formula
Cap rate = Net Operating Income (NOI) / current market value of property.
Cap rate can also be used to calculate property value. Take, as an example, a 100-unit rental building in Connecticut receiving an average of $3,600 monthly rent per unit, equal to $360,000 gross rents per month and $4,320,000 per year. If the annual operating expenses are $2,100,000 then the NOI for the building is $2,220,000. Using a market cap rate for the area of 4.5 percent, the current market value of the property is calculated by dividing $2,200,000 by 4.5 percent, which results in a $49,333,333 current property valuation.
Is a Higher or Lower Cap Rate Better?
The higher the capitalization rate, the riskier the multifamily apartment is as an investment.
Cap Rate Predictions for 2022
In 2022, Freddie Mac Multifamily expects another strong year for multifamily investment, with cap rates remaining steady or slightly increasing with interest rates. Although the two do tend to move in the same direction, many analysts do not believe that rising interest rates will have a significant impact on cap rate.
According to CBRE the average national cap rate for multifamily apartments decreased by .68 basis points during 2021. In its 2022 Multifamily Outlook, Freddie Mac Multifamily explains that, according to data from Real Capital Analytics, cap rates at the end of 2021 were at 4.7%; this is down .40 basis points from the third quarter of 2020. This is the lowest average cap rate on record.
What is a Good Cap Rate for Multifamily Apartment Properties?
Multifamily apartments tend to have a cap rate between 4% and 10%. This may seem broad, but as previously mentioned, there are many factors that impact cap rate, including where the property is located, amenities, and demand. These variances impact cap rate, operating expenses, rents, and market value. It is therefore wise to compare the cap rate of your property to those of the same Class, in similar neighborhoods, and with similar amenities. Luckily, multifamily apartments are considered very low risk and therefore tend to have lower cap rates than many other property types.
Find the Right Multifamily Apartment Loan for Your Project
Once you’ve found a project with a reasonable cap rate, your next step is to find the right loan for you. Our team can help you determine the cap rate on projects you’re considering, help you decide whether they’re a viable investment, and ensure you find the best loan for project success. Contact LSG Lending Advisors today.