What Exactly are Cap Rates?

This article breaks down cap rates in a simplified way, and explains what role they play in the world of Multifamily investing.

When I began investing in real estate - specifically Multifamily assets - it took awhile for me to truly understand cap rates and why they mattered. It seemed that any article I read or Youtube video I watched, none of them did a great job at explaining the concept. My hope is that this is the only article you need to reference in order to have a thorough understanding of this foundational metric used in Commercial real estate.

Defining a Cap Rate

The technical definition of a cap rate (short for capitalization rate) is an unlevered rate of return. Don't freak out - that's not as intimidating as it sounds. An unlevered rate of return simply means the return percentage you would receive on your investment with no debt obligation.

Let's imagine the cost of an apartment building is $1,000,000. You're in a great position financially and can afford to buy it without needing the bank to make you a loan. The apartment building will rent, all units combined, for $10,000 per month. That translates to $120,000 per year. After paying your operating expenses (insurance, taxes, general maintenance, repair items, etc.) at the end of the year, you've profited a total of $78,000. You just earned a 7.8% unlevered rate of return, because you have no debt payment to make with your $78,000 profit. This would be considered a 7.8 "cap" or cap rate.

Why it Matters

Multifamily property is no different than running any other business - you have income & expenses that make up your profit, resulting in a certain rate of return (profit / initial investment). Cap rates will determine how an apartment building is valued in the marketplace. The formula is simple: Value = NOI / Cap Rate.

78K (NOI) / .078 (Cap Rate %) = $1,000,000 (Value)

This example helps demonstrate, in very simple terms, the concept of a Cap Rate. Let's dive a little deeper.

Applying it to the Marketplace

As noted above, Multifamily properties operate and trade just like every other business. When a business is purchased, what's often being paid for is the in-place cash flow (profit). There may be a premium on that stream of cash flow based on many factors, such as current brand recognition, an existing customer base, the future upside, etc. In real estate, a few common things investors look for would be the location, opportunity to renovate, poor in place management, or if the owner is paying the utilities. All of these factors will affect the potential of the investment, in turn affecting the "going in" cap rate.

Cap Rates are simply a measure of demand. If demand is high, cap rates are low, and vice versa. This makes sense when we consider our original definition - at the end of the day, we're discussing a rate of return. If a market is in high demand due to job growth, strong in-migration, low unemployment, being business friendly, etc. then more money is going to be chasing Multifamily assets in that market. In other words, more dollars are competing for that stream of cashflow & rate of return, which compresses the cap rates. Comparing it back to businesses, a cap rate is no different than a multiple applied to business earnings, which helps determine the value of the business.

Using our same building valued at $1,000,000 at a 7.8 cap rate, we will assume multifamily assets are trading around a 7.5 - 8 cap in the market. This makes 7.8% a fair cap rate to apply to our $78,000 of income, thereby making our $1MM value reasonable in the marketplace.

Now let's imagine that 3 years pass, and a few large employers have decided to move into town which results in strong population & job growth. Investment dollars are more attracted to real estate now than they were three years prior, and cap rates have been compressed to around a 5. The same property we own with $78,000 in NOI is now appraising at $1,560,000 ($78K / .05), adding an additional $560,000 in value due to demand increasing.

If it's easier, think about cap rates as a multiple on earnings. So, a "5 cap" would equate to a 20x multiple on NOI --> $78K x 20 = $1.56MM.

(Keep in mind, the NOI in this example remained consistent to help illustrate the concept. in 3 years time, you could reasonably expect an increasing NOI due to rent increases.)

Recap

It's my hope that you found this information helpful, and now have a good grasp on what a cap rate is and why it's an important concept in commercial real estate. In future articles, we will continue to reference cap rates and the different ways in which they impact the market.

Key Takeaways

• Cap Rates are a fundamental metric to pay attention to in commercial real estate

• NOI / Cap Rate = Value

• The higher cap rates are, the lower the value of real estate assets will be and vice versa

• Cap Rates are an indication of demand. More demand = lower cap rates ; Less demand = higher cap rates

• In real estate, cap rates apply just as income multiples do in other businesses