A multi-family cap rate is one of the most important tools for real estate investors to assess the potential profitability of an investment in a multi-family property.
In simple terms, cap rate is an estimate of the return on investment (ROI) for a property. Cap rates on multifamily properties are usually expressed as a percentage. But what’s a good cap rate for multi-family properties?
In this article, we will discuss what a good multi-family cap rate is and how to calculate it.
We will also explore how cap rates can be used to compare different investments and help make informed decisions about multi-family property investments.
What Is a Multi-family Cap Rate?
A cap rate (or capitalization rate) is a metric expressed by a percentage used to measure the return on investment (ROI) for a multi-family real estate investment.
The multi-family cap rate is determined by taking a property’s net operating income (NOI) and dividing it by the current market value of the property. The higher the cap rate, the higher the potential return on the investment.
A low cap rate indicates a low return on investment and could signal an overvalued market or a riskier investment.
Conversely, a high cap rate can indicate a better return on investment and could be a sign of an undervalued property or a more secure investment.
Importance of a Good Multi-family Cap Rate
Understanding multi-family cap rates is essential for investors who are looking to make profitable investments in the multi-family market.
By understanding the cap rate, investors can better determine the risk-reward balance of an investment and make informed decisions about whether or not to invest. It provides investors with an easy way to compare potential investments by providing a snapshot of a property’s performance relative to the market.
How to Calculate Cap Rate
Cap rate, or capitalization rate, is calculated by dividing the net operating income of a property by its current market value. Simply put, the CAP rate formula would be this:
Cap Rate = Net Operating Income (NOI) / Purchase Price
To calculate the cap rate, you will need to know the property’s net operating income (NOI), which is the annual income generated by the property after operating expenses such as taxes, insurance, utilities and maintenance (CapEx) have been deducted.
Next, you need to determine the current market value of the property. This is the price the property would likely sell for in the current market. We suggest using a licensed realtor or appraiser to help you determine fair market value.
Once you have both of these numbers, you can calculate the cap rate by dividing the NOI by the market value and multiplying the result by 100. Here are some examples of how to calculate CAP rate.
- A property is currently being offered for sale for $1,000,000, and the annual net operating income is $50,000. The cap rate is 5%.
- A property is currently being offered for sale for $2,000,000, and the annual net operating income is $200,000. The cap rate is 10%.
- A property is currently being offered for sale for $500,000, and the annual net operating income is $40,000. The cap rate is 12.5%.
Factors Affecting Multi-family Cap Rate
Multi-family cap rates are affected by a number of different factors, including:
- Location
The location of a multi-family property is one of the most critical factors affecting the cap rate.
Location can impact the cap rate in many ways. Properties located in desirable areas with high demand could have higher cap rates, but will also have a higher acquisition cost. Conversely, properties located in less desirable locations will have a lower acquisitions price. Sometimes properties in less desirable areas can outperform properties in better areas because of the lower acquisitions cost.
- Property Type
A good multi-family cap rate is also determined by the type of property. Smaller multifamily properties such as duplexes and quadraplexes may have lower cap rates vs. large apartment buildings with dozens of units. Other assets such as strip malls, office buildings and self storage facilities may outperform multifamily in terms of cap rates. These types of properties have the potential to bring in higher income.
- Age and Condition
Older properties may require more repairs and maintenance vs. a newer building, which can lower the cap rate. The condition of a multi-family property when you first buy it can also influence its cap rate. If the property is older but well-maintained, it may have a higher cap rate than an older, neglected property.
- Size
The size of a multi-family property can also affect its cap rate. Generally, larger properties have higher cap rates because they have the potential to generate more rental income.
- Amenities
The amenities a multi-family property offers can also impact its cap rate. Properties with desirable amenities like swimming pools, fitness centers, and clubhouses tend to have higher cap rates than those without such features.
What Is a Good Multi-family Cap Rate?
The ideal cap rate for a multi-family property is anywhere between 5% to 10%. It’s mainly dependent on the local market and the type of property being considered. Generally speaking, multi-family cap rates tend to be lower in markets with high demand and rental prices, such as major metropolitan areas. This is primarily due to the higher cost to acquire these properties. However, properties in major metro areas tend to hold their value better so that is also something to consider.
The cap rate is just one of many factors that investors should consider when evaluating a multi-family investment opportunity. Other factors that should be taken into account include the size and condition of the property, the potential for rent growth, the potential for future development, and the overall stability of the local market.
Cash On Cash Return vs Cap Rate
Cash on cash return (CoC) and capitalization rate (cap rate) are two key metrics real estate investors use to evaluate potential investment properties. They both measure profitability, but there are some important differences between them.
Cash on cash return is a measure of the return on the actual cash that is invested in a property. It is calculated by taking the annual before-tax cash flow of the property and dividing it by the total amount of cash invested.
Cash on cash return is an excellent metric for investors who invest their own cash into a property. It gives them an idea of how much their initial investment will be returned to them.
The major difference between cash-on-cash return and cap rate is that cash-on-cash return is based on the actual cash invested in a property, while the cap rate is based on the total value of the property.
As a result, cash-on-cash return is a more accurate measure of return on the investor’s money, while cap rate is a more accurate measure of the return on the total investment.
What Is Cap Rate Compression?
Cap rate compression in real estate is a phenomenon in which the cap rate of a property decreases over time. The cap rate is a property’s net operating income (NOI) ratio to its market value.
A lower cap rate indicates that a property is becoming more valuable, and a higher cap rate indicates that a property is becoming less valuable.
The factors that can lead to cap rate compression include economic conditions, market forces, and local and national trends.
As the economy strengthens, cap rates tend to decrease. Similarly, if there is an increase in demand for real estate, this can lead to a decrease in cap rates. Changes in interest rates, inflation, taxes, and the availability of financing can also affect cap rates.
Cap rate compression is important for investors to understand, as it can affect the profitability of a real estate investment.
Investors should monitor changes in the cap rate to ensure that their investments are profitable. Cap rate compression can also be used as an indicator of how the real estate market is performing and can be used to inform investment decisions.
Markets With Best Multi-family Cap Rates
Generally, markets with higher cap rates tend to have more attractive and lucrative opportunities.
Some of the best markets for cap rates are significant cities, as they tend to have higher demand and more stability in their real estate markets.
According to Mashvisor, many markets in Florida (Vero Beach, Hallandale Beach, Stuart, Naples, Melbourne) have some of the best multi-family cap rates. Fountain Hills, AZ, Williamsburg, VA and Carmel, IN also rank high on the list. Additionally, many smaller cities and towns can offer great cap rates as well. These locations are more affordable and can offer investors a great return on investment.
Final thoughts
What is a good multi-family cap rate? The answer is it depends. 5-10% is a good target range. In conclusion, the correct multi-family cap rate for a given investment will depend on the particular market, asset class, the current state of the economy, and the individual investor’s risk tolerance. Investors should do their own research to determine the cap rate that best fits their needs.
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