Getting started in multifamily commercial real estate investing can feel like you’ve just been dropped in a foreign country without speaking the language. While it may seem very overwhelming to get your bearings at first, investing in multifamily properties doesn’t have to be a daunting task. In fact, it’s not too different from learning to speak a new language; figure out the commonly used terms and phrases, learn how and when to use them, and start making them a part of your vocabulary. Taking the time to understand a few key words and concepts at a deeper level in this space will set you up for success in the long run.

“Capitalization rate,” commonly phrased as “cap rate” for short, is one of those terms. It is often referred to as “the gold standard” by commercial real estate investors as a way to get a high level understanding of a particular investment property. There’s a lot of information packed into this one number. The simple formula can easily be calculated on the back of a napkin for a quick snapshot evaluation of a current or potential deal. While the formula itself is simple, understanding the nuances of this term and concept are what make it complex, and at times, overwhelming. It took me a while in my early investing journey to really start to understand how and when to use cap rate in analysis and why it can be really powerful in determining value and return on an investment.

In this blog, we will break down the concept of cap rate into easily digestible doses of information, along with some examples to help you take your understanding to the next level.  Our goal here is to help you understand what cap rate is, show you how it’s used, and teach you how you can use this information to help elevate your real estate investing savviness. 

Understanding the Cap Rate

First, you need to understand what cap rate is and how to calculate it. You will need a few definitions and calculations to start. Then, you can understand how to use it to your advantage. 

“Cap rate,” according to Investopedia, “is the most popular measure through which real estate investments are assessed for their profitability and return on potential.” 

Essentially, the cap rate indicates the financial return that an asset will yield each year, in the form of a percentage. The cap rate will determine how much you can expect to receive back in yearly rental income, for every dollar the property costs you to acquire. It is a snapshot of the property’s potential, indicating both the quality of the investment and the assumed risk. 

So how do we calculate this percentage? Cap rate is determined by taking the Net Operating Income (NOI) and dividing it by the value of the asset. In some cases, this value is what you paid for the property. In others, it’s what you plan on selling it for. For reference, your NOI is all of the revenue from a property, minus all necessary operating expenses. 

Use these two calculations to determine cap rate:

• Net Operating Income (NOI) = Real Estate Revenue - Operating Expenses*

• Cap Rate = NOI / Property Value 

*Note: Debt service (or the mortgage payment) for a property is not included in the NOI calculation and therefore, not used to calculate the cap rate. But isn’t your mortgage payment an expense? Yes, but loans vary from property to property and investor to investor, therefore it would be nearly impossible to use a consistent calculation that takes debt service into consideration without skewing the cap rate. In this case, we approach defining the “Property Value” number as if we paid in cash.

Let’s take a look at a cap rate example: 

You purchase a 20-unit multifamily at $2M. 

The current NOI (Real Estate Revenue - Operating Expenses) is $100K.  

NOI / Property Value = Cap Rate

$100,000 / $2,000,000 = 0.05 or 5% cap rate. 

How To Use Cap Rate

Cap rate can be used on the front end of a potential deal upon purchase. This is known as “entry cap rate.” The alternative is known as “exit cap rate,” which is used to evaluate the future resale price of a property. Both numbers are important to understand and are notable pieces of the commercial real estate puzzle. 

Entry Cap Rate

Entry cap rate, sometimes referred to as “going-in cap rate” or “initial yield,” is a quick way for an investor to evaluate whether the asking price is within reason. A low cap rate percentage could indicate several red flags, specifically an asking price that is too high for the given market.

A lower cap rate, especially under 3%, could also indicate that the property is under rented and therefore, yielding a lower NOI. Let’s use the same example above. A $2M property that has an NOI of only $50K (instead of $100K like above), the cap rate drops from 5% to 2.5%. You can see now how that 2.5% can be an indicator that the NOI is pretty low compared to the price of the property. An under-rented property offers room to increase rental income, thereby increasing NOI and increasing the cap rate. 

A value-add property may have a lower cap rate, as there is the opportunity to increase the property value (or your NOI) with appropriate renovations. On the other hand, a stabilized property with little to no upside potential will typically yield a higher cap rate percentage. 

Remember, cap rate is still market specific and doesn’t necessarily indicate if a deal is “good” or “bad” if you just skim the surface without diving into what is driving the number. It really depends on your strategy and what kind of opportunity you are looking for as an investor. For example, recently, the Seattle market was trading class A assets (more upscale apartment buildings) at a 3% - 4% cap rate. This was because these assets were incredibly overpriced. Again, this doesn’t mean it’s a bad investment. This type of investment may be appealing if you are looking for a predictable asset in a historically strong renting market. 

Now that you understand the basics, let’s look at how the cap rate equation can be flipped around to answer different questions. For example, if you know that the market cap rate in a particular area is 7% for the asset class you’re looking at, you could move the numbers around and use it to determine a reasonable offer on a desired property. 

Let’s go back to our original example of a property with $100,000 in NOI. Knowing that the market cap rate is 7% divide the NOI by the 7% market cap rate to determine your offer. Adjust accordingly based on the current market cap rate specific to the property’s asset class. 

$100,000 / 0.07 = $1,428,571 as a reasonable offering price. 

Varying factors can significantly change the capitalization rate including rental income, vacancy rate, current expenses related to the property, market valuation, and value-add potential. As the investor, understanding that the cap rate could indicate a variety of different scenarios, it is your job to dig deeper to find out if the property is worth your time, energy, and effort and how you could increase your return on investment. 

For example: 

Going back to our original example, let’s assume you completed a set of value add projects and increased the rent as a result. The projects allowed you to increase your NOI from $100K to $120K annually. The market cap rate is still 5% (remember back to the original example where we found our cap rate for this property to be 5% because NOI was $100K and purchase price was $2M). Using this new NOI and the same cap rate, you can increase the property value to $2.4M, which is a 20% increase (or $400K more) from the original purchase price.

$120,000 / 0.05 = $2,400,000 ($400K greater than the original $2M purchase price)

Expanding on this example, let’s say that when you purchased the property, you only actually used $500K of cash upfront instead of paying the full $2M purchase price in cash. Your investment return is 80% ($400K profit from the increase in purchase price/$500K cash you put down to purchase the property). If you’re ever wondering how syndicators are getting these 80-100% return on investments in 5 years, now you know the secret! You can see how just an annual $20K increase in NOI resulted in a $400K increase in the value of the property, and how leveraging debt to your advantage allows you to maximize your returns. It’s also why it’s critical to know your market cap rate when doing these kinds of calculations. 

Exit Cap Rate

Exit cap rate, also known as “terminal cap rate,” is used to calculate the future price of a property based on its expected NOI at the end of the investor holding period, or at the time of resale. 

Exit cap rate is used by brokers and sellers as a marketing tool to attract potential buyers. The exit cap rate shows potential buyers the current and potential NOI while also offering buyers a transparent look at the asking price. 

A prospective buyer may use a projected exit cap rate to determine future capital gains on the asset. Estimating the future cap rate of a specific property is a delicate and highly technical task. The estimate should be done using econometric analysis and historical cap rates at the market and property type level. 

An exit cap rate lower than the entry cap rate will typically result in a net gain due to the increase in property value. As a general rule of thumb,  look for markets where cap rates are decreasing and NOI is increasing if you are seeking an investment with a higher rate of return. 

Future cap rate estimation is an incredibly sensitive process. A slight fluctuation between the expected exit cap rate and the actual rate upon resale could dramatically change the sale price of the property. 

Referring back to the original example, let’s take a look at how a fluctuation in the exit cap rate could change the situation. As a reminder, our Purchase Price was $2M and our original NOI at the time of purchase was $100K. To calculate resale price:

Resale Price = NOI / Cap Rate

At an assumed 4% exit cap rate, $100,000 / 0.04 = $2,500,000

But changing the estimated exit cap rate in the above example to 6% results in a drastically lower resale price of $1,666,666. 

The difference between 4 and 6% is a fairly wide gap, however, cap rate changes as small as 0.25% can greatly affect the resale price.  If we take a more realistic scenario using our original example after we had made improvements to the NOI, we can see just how this plays out. Remember that we increased our NOI from $100K to $120K after all of our hard work doing renovations and improving the community in our complex. At that time we projected the exit cap rate to be 5%, but say the market cap rate actually changed to 5.25% (a 0.25% increase).

In the previous scenario of an exit market cap rate at 5%, our resale price was $2,400,000:

$120,000 / 0.05 = $2,400,000 

In this new scenario where our exit market cap rate is 5.25%, our purchase price goes down to $2,285,714:

$120,000 / 0.0525 = $2,285,714

That means your projected value/price for this property is about $114K less than previously estimated at a 5% cap rate. Remember that 80% return on the investment? This small fluctuation brings us down to 57% return ($286K increase in value / $500K cash investment). You can see how even a 0.25% fluctuation in cap rate can result in a big change in your estimations of return and why it’s important to know your cap rates and do sensitivity analysis to know possible outcomes. 

Take a look at this incremental chart from property-investment.net for an even more detailed  view of the possible fluctuations in resale price based on changes in the estimated cap rate. This chart shows resale value estimates for a hypothetical property with an NOI of $100K.

Conclusion

Understanding cap rate, as it relates to multifamily investments, puts you in an advantageous position to negotiate the purchase price, increase profits, and collect future profits upon resale. If your head is spinning after all of the formulas and calculations in this article, don’t worry. It takes time to understand these concepts. Get a pen and paper or a spreadsheet open and play around with the formulas and numbers. Keep these calculations in your back pocket as you start evaluating properties for investment or projecting returns after a project has gone full cycle. Having an in-depth understanding of these concepts will help you make smart investment decisions, especially as you grow your portfolio. 

Key formulas to remember: 

• Net Operating Income = Real Estate Revenue - Operating Expenses 

• Cap Rate = NOI / Property Value 

• Resale Price = NOI / Cap Rate

Ready to learn more about multifamily investing, cap rates, and more? Explore our courses or community for everything you need to achieve financial freedom through real estate investing.

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