Cap Rates for Commerical and Multifamily Properties Explained
Cap rate is one of the most popular ways to calculate a commercial or multifamily property’s return on investment (ROI). Cap rate, also known as capitalization rate, is calculated by dividing the net operating income of a property by its market value.
Cap rate metric represents the unleveraged return on a property as if no loan had been taken out. Properties with higher cap rates are more profitable than those with lower cap rates but typically carry additional risk.
For instance, B and C class properties, including properties in disrepair, and those in bad neighborhoods generally have higher cap rates. In contrast, class A properties and those in good areas typically have lower cap rates.
What is the Formula for Cap Rate?
As mentioned previously, the formula for cap rate is:
Cap Rate = Annual Net Operating Income (NOI)/Market Value
The formula for net operating income, or NOI, is:
NOI = Gross Operating Revenue - Gross Operating Expenses
Gross operating revenue is revenue before operating expenses and other costs. Gross operating expenses include:
Property maintenance
Vacancy
Taxes
Insurance
Maintenance
Other expenses
Cap Rate Example
For example, a property worth $1 million with $70,000 of annual net operating income would have a cap rate of 7% ($70,000/$1 million = 0.07/7%).
How Do I Use Cap Rate to Compare Real Estate and Other Investments?
Cap rate can be a great way to compare different real estate investments. However, investors need to be careful when using this metric. Cap rate is best used to compare very similar properties, say, two B class, 20-30 unit apartment buildings in the same MSA (Metropolitan Statistical Area).
Since a property’s cap rate varies with risk, it wouldn’t be appropriate to compare a C-class apartment in a bad neighborhood with a shiny new A-class apartment complex in an affluent downtown neighborhood.
Similarly, it may not be the best idea to compare cap rates across different assets, such as comparing the cap rate of an office building to the cap rate of an industrial property.
Can I Use Cap Rate to Compare Real Estate With Other Investment Types?
If a property has been purchased fully in cash, it will reflect the full return of the investment and can be compared to the annual return of stocks, bonds, or other similar investments. However, in most cases, investment real estate is financed with loans and therefore has a significantly higher rate of return than the cap rate alone accounts for. This is why using cap rate often isn’t the best way to compare different investments.
A more flexible metric, such as IRR, is often a better way to compare real estate investments to investments in other types of assets. This is why IRR is often used as a measure of return by alternate asset managers, such as private equity fund managers, to compare real estate and other types of private equity investments to each other.
What Are The Factors That Influence Cap Rate?
A variety of factors can influence cap rate, including location, property type, age, and the number of units.
What is Risk Premium and What Does It Have to Do With Cap Rates
The only investment considered mostly “riskless” is U.S. Treasury bonds. Treasury bonds currently return 1% interest. A return over and above the “risk-free rate” is considered a “risk premium.” So, if an unlevered property had a cap rate of 6%, and the return on U.S. Treasury bonds is 1%, the risk premium would be 5%.
The risk premium is simply a way to demonstrate that an investor is rewarded for the additional risk they take on a transaction above the rate they could get from a “risk-free” investment.
Can Cap Rate Change?
Cap rates can, and do, change constantly. If a property experiences vacancy or higher expenses while the market value stays flat, the cap rate will go down. Conversely, if a property raises rents or reduces expenses while the market value stays the same, the cap rate will increase.
For example, if the NOI of a $1 million property decreases from $70,000 to $65,000 due to vacancy, the cap rate will fall from 6.5% to 7%.
In contrast, if rents increase from $70,000 to $75,000, the cap rate will increase from 7% to 7.5%.
Changes in market value also impact cap rates. All other factors held steady, an increase in market value will decrease a property’s cap rate, while a decrease in market value will increase the property’s cap rate. Therefore, if the cap rate of a property increases, that isn’t always a good thing for an investor currently holding the property.
What is the Difference Between Cap Rate vs. Equity Multiple?
Cap rate represents the ROI of an investment without factoring in the impact of debt. In contrast, equity multiple represents the amount of cash generated by an investment compared to the amount of equity invested. A property with an equity multiple less than 1 means that a project has lost money, while a property with an equity multiple greater than 1 means the property has made money.
In essence, a cap rate is a representation of a property’s annual unleveraged return, while equity multiple is the amount of money returned to an investor over the life of a project compared to the amount initially invested. Money returned to investors includes all cash distributions as well as the distribution of sales proceeds at the end of a deal.
What is the Difference Between Cap Rate vs. IRR?
Cap rate and IRR are two distinctly different ways to calculate the profitability of a real estate project.
Technically, IRR is defined as the discount rate at which the net present value (NPV) of a series of cash flows from an investment equals zero. In layman’s terms, it is the compounded rate of return for a project. It essentially takes the total return of a project and backdates it over the time horizon of the project itself.
Cap rate, as we’ve mentioned before, is the annual return on a project without any leverage. Most calculations of IRR incorporate a project’s leverage, so, therefore, leveraged IRR is often a much better way to compare similar projects than looking at cap rate alone.
However, IRR can be subject to similar limitations as cap rate. IRR is best when comparing two similar projects (i.e. similar property type, size, and submarket) over the same time period. IRR is especially effective at estimating the return for projects that may include significant construction, such as new commercial or multifamily developments or projects that involve significant renovations.
Using IRR to compare totally different investments can still work, but it can be misleading to the different risk profiles of different types of commercial real estate investments (or other investments, such as private equity or hedge funds).
Can You Use Cap Rate and NOI to Estimate a Property’s Value?
Yes. To determine an approximate price of a property using NOI and cap rate, you can divide the NOI by the comparable cap rate of similar properties to calculate an estimated property value.
For instance, if an apartment building generated $100,000 in annual NOI, and the cap rates of similar buildings in the area are 5%, you can divide $100,000 by 5% to create an estimate of property value.
$100,000 (NOI)/0.05 (Cap Rate) = $2,000,000 Estimated Property Value
In Conclusion: Cap Rate is an Effective Metric, But Shouldn't Be Used In Isolation
Overall, cap rate can be a great way to measure the potential ROI of a property, however, it has its limitations. Using cap rate along with other metrics, such as IRR and equity multiple, can give a commercial real estate investor a complete picture of the potential profitability of a real estate asset.
Like other metrics, investors may wish to calculate potential (future) cap rate within a range, forecasting positive, negative, and neutral market conditions. This will avoid overly optimistic or pessimistic predictions and can help provide investors with a more holistic investment perspective.