Real Estate Investing Basics

What’s a Good Capitalization Rate for Real Estate Investments?

Expertise: Mortgages & Creative Financing, Personal Development, Landlording & Rental Properties, Personal Finance, Real Estate News & Commentary, Real Estate Deal Analysis & Advice, Real Estate Investing Basics, Business Management, Commercial Real Estate
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Since prehistoric times, we humans have been in the business of evolution. Such is the scientific truth. Unless, that is, we are on BiggerPockets talking about cap rates, in which case there appears to be no evolution.

It seems the same old misconceptions prevail, and the same lack of conceptual understanding remains. We seem unable to mature in this respect. I am not sure if this article will fall on deaf ears, but I am willing to take another stab at cap rates regardless. I truly hope some of you find this helpful.

What Is Capitalization Rate?

First, let me say this. Cap rate is NOT a metric of investment return, which is why we are careful not to lean on it as our acquisition criteria. Think of cap rate as an indicator of market sentiment.

Let’s talk this through.

As investors, we aim to identify the rate at which we can grow our investments on a risk-adjusted basis. All of us have parameters with regard to this, but for all of us, there is a point whereby growth potential outweighs the perceived risk premium by enough of a margin to influence us to take action and to deploy capital.

Man Working Home Office Start up Ideas Concept

Well, since in the real estate market risk in large part is defined by a location’s economic fundamentals, for a lot of investors the rationale goes something like this:

I know I have to pay more to be in that location, but because of the superior economic indicators in this location, I feel my money is safer there long-term. Other people think like me and pay more to be in this location, which forces me to pay more to be here. But I am willing to pay more today because I think there will be more sustained growth here in the future. I know that my rate of return may be lower, but safety is paramount to me, so I am willing to accept lower returns.

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The above rationale causes people to pay higher prices for the assets relative to the net operating income (NOI), which, of course, backs out as a lower capitalization rate on an in-place basis.

Related: Cap Rate—A Must-Have Number for Rental and Commercial Investors

Benefits of Lower Cap Rates

For many years, I thoughts I was the smart one, buying in Ohio at 10 percent cap and thinking that all those people paying 5 percent cap were stupid. But the more I studied, the more I gained an appreciation for the fact that people buying at low cap rates have already made all the money they’ll ever be able to spend. They are willing to pay a premium for safety instead. And the reason they would go into a market and deploy at 5 percent cap is that they feel their money is safer there than somewhere else.

So, when I see BlackRock deploying a billion dollars at 5 percent cap in a market today, the only comment I have is, “How do I get in on that?”

Benefits of Higher Cap Rates

I am not specifically discussing value-add in this article, which is an integral component but lies outside the scope for today. That said, here’s some rationale.

Clearly, I cannot simply buy a value equivalent to 5 percent cap. Nothing cash flows at 5 percent cap, and I do need some cash flow in order to hold onto the asset long enough for it to do its thing. And unlike those other folks, I still need to create wealth. So, if I must buy at 5 percent cap because such is the market, what I can do is find an asset whereby having paid a price equivalent to 5 percent cap, I can then improve it to where my new income will represent a 7.5 percent cap upon my basis.

Close up of businessman or accountant hand holding pen working on calculator to calculate business data, accountancy document and laptop computer at office, business concept

In this case two things happen:

  1. I will cash flow well at 7.5 percent cap.
  2. I will create a lot of value, because while the re-positioned NOI represents a 7.5 percent cap upon my basis, I am still in a market that trades at 5 percent cap rate. When I go to sell or refinance the asset, this delta of 2.5 percent cap represents millions of dollars of value. This value is what I am really after, since I want to create wealth.

So, in the end, I will have not just the cash flow but also wealth to go with it. Perhaps I should turn that around. In the end, I’ll have wealth and some cash flow to go with it. And I am much more likely to achieve this desired result in a low cap market.

Why? Many structural reasons, but that’s another article altogether.

Related: Still Confused About Cap Rate? Here’s an Experienced Investor’s Explanation

The Bottom Line

I am bullish on multifamily in growth markets. But while this cycle could run for another five years for all I know, this cycle is mature.

As we all know, the tide raises all ships. But in terms of real estate markets throughout the country, some markets cause the tide while most just ride the wave.

This is why we have bought $40MM of real estate in Phoenix this year—five million population in the MSA, job growth, diversified GDP, good rent to income ratio. Those are all metrics that define the strength of any market, and this late in the cycle, I want to be in the best market that I can—even if I have to pay 5 percent cap.

Hopefully, this helps some of you.

Any other questions I can answer for you about cap rates? 

Ask me in the comment section below. 

Ben has been investing in multifamily residential real estate for over a decade. An expert in creative financing, he has been a guest on numerous real estate-related podcasts, including the
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    Marc Brenner Realtor from Atlanta
    Replied 6 months ago
    This made a lot of sense, thank you for writing it. Any tips on analyzing a market? What questions to answer and resources for finding the answer?
    Ben Leybovich Rental Property Investor from Lima/Chandler, Ohio/Arizona
    Replied 6 months ago
    Mark, thanks for reading! In terms of the Cap Rates, since you are really analyzing the trading activity, the best resources are the brokers. They are the closest to this activity and can offer the most time-sensitive guidance. Most national brokerage houses track this stuff and publish reports. Get on their email lists.
    Ben Leybovich Rental Property Investor from Lima/Chandler, Ohio/Arizona
    Replied 6 months ago
    Sorry, Marc, for the spelling :(
    Rachel Foster Rental Property Investor from Chicago, IL
    Replied 6 months ago
    A lot of great info! Thanks for spending time writing this blog!
    Ben Leybovich Rental Property Investor from Lima/Chandler, Ohio/Arizona
    Replied 6 months ago
    I am glad you found it useful, Rachel. Thanks!
    Patrick Liska Investor from Verona, New Jersey
    Replied 6 months ago
    Ben, To "Lower" your CAP rate do you rely on Tax incentives to get the 5% to 7.5%, or do you increase maintenance budget ? how would one do that without costing them extra money while bringing in more steady income?
    Dirk Jackson Investor from Lima, Ohio
    Replied 6 months ago
    Hi Ben. Thanks for the post. Right now in Lima it's hard for us to resist the "pigs" that can go from 12% and up return. We want to buy as many as we can to build up cashflow and eventually transition to multifamily wealth play. I've read in the past how you feel about these single family properties. So what do you suggest if I want to stay in market and continue to grow wealth? Thank you.
    Dupree Morrison from Brooklyn, New York
    Replied 6 months ago
    Good information
    Rich Hupper Broker / Investor from Tewksbury, Massachusetts
    Replied 6 months ago
    This is a great article thanks for writing it.
    Katie Rogers from Santa Barbara, California
    Replied 6 months ago
    The gross cap rate on new purchases in my community is 3-4%. The only people with cash flow are landlords who purchased decades ago. Meanwhile, our local real estate agents tell people that throwing the dice for appreciation is a perfectly valid investing strategy.
    Ben Leybovich Rental Property Investor from Lima/Chandler, Ohio/Arizona
    Replied 6 months ago
    Thanks so much for reading, guys! Patrick - I am not sure I understand the question. The cap rate is calculated at the NOI level, before the debt service and therefore before cash flow. The tax incentives, if any, are individual to each investor's situation. All of the investment returns projection are done on a pre-tax basis. As the NOI goes up through value-add, the resulting cap rate unpon the initial investment basis comes down. I don't, and cannot, manipulate the cap rate, as it is a market-driven metric. All I can manipulate is the income and expenses. Dirk - I guess to each his own. After 10 years your opinion might change :) Katie - CA is a different story altogether. SInce hoping for appreciation is a bad strategy, what w need is what we call value-add, whereby we can improve the property and operations and raise the revenue. IN CA, in many municipalities, there already is rent control, and now it looks likely that it will be state-wide. If this is the case, then the value-add play is becoming structurally impossible in the entire State. So, go somewhere else, like Arizona :)
    Patrick Liska Investor from Verona, New Jersey
    Replied 5 months ago
    Ben, you answered my question, just as i thought, the only way to increase the NOI would be to spend money and Value Add to the property, unless you find a way to value add without spending. I was just wondering if you had another way of "saving" to increase your NOI that could be implemented.
    Joe Bueno Flipper from Sacramento, California
    Replied 6 months ago
    Here' an alternative we've been working with. While building up capital to purchase multi-family rentals, we purchased a nice mobile home in northern California and one in Clearwater and run a manufactured home flipping/renting business in both places. This enables us to pay a minimal monthly rent and when capital is built up and we have a strong monthly passive income we will sell the mobiles and make a bit more than our initial purchase/rental fees and get nice rentals wherever we please. We will then in addition to the flipping/rentals of individual manufactureds we will have the capital to buy larger multi-family units and/or mobile parks. Working well so far- living nicely and about 6 months away from our 1st multi-family purchase!
    Mike Krieg Investor / Syndicator from Austin, TX
    Replied 6 months ago
    Nice job Ben! As always! Very clear and helpful!