What is a Good CAP Rate For Multifamily Investing?

Understanding CAP Rate in Real Estate is Part of the Investment Balancing Act 

A CAP rate, or capitalization rate, is an important measurement to understand when you’re considering real estate investing. Evaluating prospective multifamily investments can be a balancing act. When you’re measuring several factors at the same time to decide the risk-reward ratio that’s right for you, understanding all of the terminology and how it plays into the overall picture is a must. 

We’ll discuss what CAP rate means in real estate and answer the question that’s probably on your mind: What is a good CAP rate for multifamily investments? 

What is CAP Rate? 

The capitalization rate of a commercial real estate property is one way to measure its profitability, expressed as a percentage. CAP rate is calculated by dividing the property’s net operating income (NOI) by the purchase price. NOI is how much a property generates after all other operating expenses are taken out – insurance, maintenance, property taxes, and so on. 

CAP Rate Calculation = NOI / Purchase Price 

Let’s put this into context. A property that was purchased for $500,000 that generates $40,000 in NOI per year would result in a CAP rate of 8%. This means the return on investment each year would be 8%. 

What Can Affect a CAP Rate? 

Many different factors can affect a CAP rate, including the type of property being analyzed, its condition, how the market is going, where the investment property is located, and what current interest rates look like. 

• Location: High-demand areas can contribute to lower CAP rates than those that are off the radar. Investors are willing to pay more for the same income given the stability and predictability.  
• Property Type: Similar to location, property types that lend themselves to offer consistent stream of of income, such as multifamily apartment complexes and retail buildings, have lower CAP rates than single-family homes. 
• Interest Rates: When borrowing becomes more costly, the investors appetite for real estate and other assets decreases and which forces CAP rates to increase for projects to stay competitively profitable. Generally, higher interest rates increase CAP rates.  
• Market Conditions: Rates can also be impacted by market conditions – strong markets with higher demand can lead to lower CAP rates.
• Property Condition: Properties that need repairs tend to have higher CAP rates compared to those in good condition. Due to the risk associated with the quality, consistency of income and risk associated with maintaining and running the property, the value of such properties is lower and hence the higher CAP rates. 

What is a Good CAP Rate? 

Well, it depends. A good CAP rate for multifamily properties can be anywhere over 4%, with most falling between 5-10%. Again, the location, condition, class, and interest rate of the property, as well as overall market conditions, all play into this.

How Might This Vary Based on the Market? 

It’s important to understand that a higher CAP rate isn’t necessarily better. Higher CAP rates can be indicative of more volatility or less desirability in the market, not just profit potential. Perennially popular locations can have lower CAP rates compared to less desirable areas, but they also tend to have lower tenant turnover and less employment volatility in these areas. A good CAP rate in an in-demand market might be 6-7%, compared to an up-and-coming market at 8-10%. 

Benefits and Drawbacks of Using CAP Rate 

CAP rate doesn’t only miss the nuance of different markets – it’s not a good practice to use just one metric to make well-rounded investment decisions. 

While CAP rate can be easy to calculate and provides a good starting place for evaluating multifamily investments, it can also be misleading when used on its own. All the factors that affect a property’s value aren’t included in just one figure. Be sure to consider associated risks with the investment and overall market conditions. Higher risk can be associated with higher CAP rates and rates of return, but more unpredictable.

How to Use CAP Rate to Determine Future Investments 

As we said, the CAP rate of a property can be a great place to start, but you should also think about other opportunities that may come from an investment. If a property needs renovations, how easy will they be? Will there be value-add opportunities to increase the NOI of the property over time? What are the vacancy rates like, and how susceptible is the area to market volatility? These considerations, paired with CAP rate, will help you figure out whether the multifamily property you’re evaluating is a good investment. 

Investream’s Approach to Investing

Our methodology ensure we look at all angles of the investment. We like to buy at a higher CAP rate than the market and sell below. We always focus our investments in above-average national rent growth, job growth, and population growth areas. Many of the Texas markets satisfy our criteria, hence, our focus on Texas. We also like to buy properties where the area class is relatively better than the property class. This gives us room to upgrade the property in a strong demand market and ensures that our investors enjoy normal market appreciation. In addition, we have the leverage to force appreciation by materially improving the condition of the property. All of these factors lead to lower CAP rates.

No one controls the market, but smart investors can adjust their acquisitions strategy and buying criteria based on what they see in the market. It’s important to apply the right business plans to de-risk and maximize potential returns. That’s what we focus on at Investream. 

Want to learn more about our investing criteria? Schedule a call with us today!