Capitalization Rate (Cap rate for short)
Rate of return on a real property asset with a given Net Operating Income or “NOI” and Property Value.
Cap rate = NOI/Property Value
Cap rate is a financial metric used to analyse the investment return of a given real property. This basic use of cap rate is the “going in” cap rate. Put another way, the cap rate is return on investment if the property were purchased all cash. Thus a .10 or “ten cap” would be a 10% return on the investors capital or cash. Sophisticated investors also use an “exit cap” or “terminal cap rate” to calculate an Internal Rate of Return or “IRR” that basically is a total return on capital or cash when looking at total cash flow, principal pay down, and gain at time of sale.
Used in a sentence:
The 20 unit apartment building is valued at a seven and a half cap by the listing broker.
Cap rates are most often discussed on commercial multifamily properties (5+ units). The larger the property (more units), the more likely the expenses are agreed upon by the market and investors. This is true because larger properties almost always have property management expense allocations. Sophisticated investors make sure that all time, theirs or staff or contractors, is accounted for as an expense. On smaller properties like a duplex, triplex, or fourplex, expense assumptions vary greatly, especially for property management, maintenance, and capital reserve, thus cap rate is typically not the preferred financial metric.
Cap rates trend from low in “A” locations and “A” condition properties (5.0-7.0) to “C” locations and “C” condition (8.0-12.0). Cap rates fluctuate up and down over time corresponding to interest rates and the strength or weakness of the real estate market or submarket.
Cap rates are always relevant for acquisition analysis whether an investor is purchasing a small or large multifamily property. That said, other metrics, such as Gross Rent Multiple and Cash on Cash may be more relevant. InvestProp recommends small property analysis (2-4 units) stick to Cash on Cash return and Gross Rent Multiple analysis and larger property analysis use Cap Rate, Cash on Cash, and IRR.
Be VERY, VERY skeptical of ALL cap rates stated in multifamily property marketing packages or tossed around by your partners or friends–“Hey this deal is a 9.0 cap in a B neighborhood you should get in this deal.” Always drill down on the expenses that contribute to the NOI. The pitfall is that a cap rate in a marketing package is only as accurate as the expenses are realistic. If the expenses in an offering package pro-forma are too light, the cap rate will skew high and seem like a better deal than it is.
What is the cap rate for your submarket? Contact InvestProp to find out!!
Thanks–and look for more terms in the InvestProp Glossary!
–Brad Schaeppi, founder and CEO