If you still care about cap rates read this...

21 Replies

Ok, Cap rates are important, however they are such a small part of your decision-making process. The amount of times I hear “I only buy 7 cap deals” is maddening. If you really think evaluating commercial multifamily apartments is as easy as looking at a cap rate and then saying yes or no, you’re delusional. That would be like Warren buffet saying, “oh yeah, I just stare at the Earnings per share on a stock and if it’s not x then I don’t buy.”

Cap rates are one part of a large equation. You have to consider the potential upside such as rental increases, RUBS additions or other forms of supplemental income (make sure the local sub-market will support these additions) that the complex in question is currently not taking advantage of. You have to look at the expenses and decide why are they are either too high or too low and how can you change them with an effective business plan. ALSO, running the business plan by your property manager or potential property management partner, prior to you even submitting an offer. You have to see if the business plan is going to actually be possible to carry out. All of your projections mean nothing if the back-end partner can’t actually make them a reality.

A cap rate is merely one lever in the value formula of: NOI/Cap rate = purchase price. When you consider the exit sale, you'll see that if you increase your NOI during the hold period the low cap rate actually benefits you and has the effect of making your sale price even higher. Low cap now becomes a pro not a con.

A cap rate is a metric of price, but it’s also an indirect assessment of risk. The lower the cap rate the more demand and the more potential exit buyers you have available to you. If you buy a 10-cap deal in the middle of Idaho it may be a good upfront at the buy, but if anything happens to the industry in the town your vacancy will sky rocket and then you’re left with an apartment that no one in the world will buy from you. Bottom line: you get what you pay for.

In conclusion, cap rates are an important thing to take note of but please do not stop your analysis at the cap rate. Please consider the whole picture and please do not say that you “only buy 7 caps hands down nothing else.” Open your mind and be flexible with new information on a case-by-case basis.

Welcome to BP, @Kyle Marcotte !  I noticed that this is your first post.  And what a great way to start!  What you said is so true.  

Cap rate is a measurement of market sentiment.  It is not an indicator of performance.  People so often confuse that.  I think that cap rate is one of the most misused, and over-rated, calculations in commercial real estate.

Thanks for posting. Its still one of many good KPI's to post. Although, I dont think I hear "i only buy x cap rates" all the time, or ever. lol. Cheers, welcome to BP. 

@Kyle Marcotte - I second Brian. A hell of an introductory post.

Almost like saying - hey, there need to be more people on BP with a brain, so here I am...

Well, to that I say, welcome to BP!

I am under contract on another community. This will be number 4 this year. Each was bought under 5 cap upon T12. Each has $300+ per door upside. Each will be at 7.5 Cap after the re-positioning.

You are exactly right.

@Kyle Marcotte I agree with you. Cap rates are over rated in my opinion. Most of these deals that are being syndicated are being leveraged with debt. Are biggest metrics we pay attention to is the CoC return, the IRR, DSCR and break even occupancy ratio. Cap rates may mean more if you're using all cash.

@Tj Hines Yes, I totally agree that the Cap Rate is overrated. However, it is definitely a good way to analyze how to increase value. Cap rate is NOI/Selling Price and you can interchange that as Selling Price = NOI/Cap Rate. You want to increase the selling price or value of you apartment? Then increase the NOI. How do you increase the NOI? Well you see where this is going. My all-time favorite metric though is CoC return and is sometimes overlooked to why it is very important for one aspect. Every investor should ask, how soon will I get my money back? CoC will tell you that and I could be wrong, but most would like to get their money back in less than 5 years at least.

@Spencer Hilligoss :

In my opinion KPI's are important to give you a general sense of a property. They help you set a basic criterion when you are first staring your underwriting of a deal and they make it easier for you to pitch a deal to people interested in investing in the deal. If I had to choose some must have metrics, I would say DSCR and CoC are perhaps the most important to me because I need to be certain that there is some element of buffer from the risk of losing the property in the event of a market shift or an unexpected issue in the structure of the property that causes vacancy or expenses to rise. At the end of the day our job as investors, in anything not just real estate, is to not lose money and focus first on taking care of the downside and worst-case scenario. Once I insure some level of safety, then I look to other KPI's such as IRR and overall annualized returns to see if the risk I am taking on will have a measurable reward.

HOWEVER, the main point I was trying to make with my initial post is that while KPI’s such as the cap rate are important and have a valuable place in our underwriting and decision making, they are not everything. The spread sheet can only tell you so much of the story. You have to have an understanding for the specific property and map your projections based on what that specific property will allow you to do as far as increasing revenue and decreasing expenses. It is an ever-changing ecosystem of humans that you are purchasing after all, not just a set of numbers on paper. When you look at it from this prospective, then I believe you are able to see the true nature of the risk that you are taking on.

This means what is the demographic of the tenants in your property, where do they work, what is their general income level, how will your increases in rents and fees compare to the neighboring apartments etc...? Questions and thoughts of this nature, to me, are the most important part of understanding an apartment complex, and the risk associated with it. If you do not consider these things, then your KPI’s will not be accurate and will fall short; thus, upsetting any investors you may have promised said KPI’s to.

The Capitalization Rate (Cap Rate) is the most widely used metrics by investors. It calculates a rate of return for a property if it is purchased all cash. The cap rate is computed by dividing the Net Operating Income (NOI) by the Value (asking Price) (i.e., Cap Rate = NOI / Price). For example, if a property produces 10k of NOI per year and is purchased for 100k, this represents a 10% cap rate. Additionally, we can also determine the NOI of a property if we have the cap rate and price of the property through Cap Rate * Price = NOI

Other metrics can be calculated using the cap rate equation. For example, the property value can be computed by dividing the income by the cap rate. From this calculation, it can be shown that the higher the cap rate, the lower the price/value of the property and likewise, the lower the cap rate, the higher the price/value of the property.

The cap rate is the rate of return for the investment as well as a measure of risk. Since the cap rate is a measure of return, the higher the cap rate, the greater the perceived risk to the income.

This is a metric that should be compared to the corresponding market cap rate for a given location and property class. For example, the cap rate for a C class property in Columbus, Ohio will differ from a C class property in Baltimore, Maryland. Different cities will have varying degrees of risk and thus the cap rate will differ.

The table above shows an average of the cap rates by property class.

Two methods of determining the amount of risk are by: 1) comparison to a risk free investment and 2) comparing to the market cap rate.

The least risky investment is the 10-year U. S. Treasury Note. This investment is guaranteed by the U. S. Government. Historically, the cap rate for a real estate investment has been roughly 3.5 percentage points above the treasury rate. The difference between the cap rate in the treasury rate is considered the risk premium, or the amount you are paid for taking the risk of purchasing real estate.

If a property does not provide the ability to reach or exceed the spread between the treasury rate and the property’s cap rate, then you may want to consider other investments.

Property Cap Rate vs. Market Cap Rate

The most important comparison of a property’s cap rate is how it compares to the cap rate of the market/location in which the property exists.

It is important to find out what the market cap rate is before making and offer. Once we know the market cap rate, we can begin to construct the ranges of risk. There is a moderate risk area that is just above and just below the market cap rate. The risk in this area fits what is reflected by the market. This means that the vacancy rates and expense rates for the property is similar to that of the market.

If the property’s cap rate is above the moderate range, then the property’s characteristics are not reflective of the market. It is likely to have higher vacancy and expenses, as well as other problems. If this property is purchased, there must be a robust plan to bring the property’s characteristics in range of the overall market (reposition/stabilize).

If the cap rate is below the moderate range, then the property’s features will exceed that of the market. These would typically be Class A or B properties, or properties with the features of a Class A or B. These properties are generally purchased as a store of value or tax purpose, rather than high returns.

Which Property has the Best Cap Rate?

In the table above, each property is in 3 different markets and offered for $500,000. The market median cap rates and the NOI for each property are listed.

Generally, you would like to buy the property with the highest cap rate (i.e., Property C) as this implies the highest return on your investment. However, there are other issues to be addressed here. The Pro Forma Cap Rate is the rate based on the stabilized property's NOI. This provides a view of what the returns would be once the issues with the property has been addressed.

Investors usually want to buy a property at the highest cap rate and sell at the lowest cap rate. Property C has the highest cap rate at time of purchase. If we consider buying property based on what we can sell it for, once stabilized, then we would purchase property A. However, when we compare the properties to the median market cap rate, all the properties are lower than the market cap rate, which implies that the price of these properties are in the top half of the market prices.

If we use the market cap rate to calculate price, then, we see that property B is the worst value (furthest away from the $500K offering) and property A is the best value (closest to the $500K offering). Another way to look at this is that property A is closest to the market cap rate at time of purchase (5.9% vs. 5.0%) than the others.

One of most effective uses of cap rates is the Band of Investment (BOI) approach because it allows an investor to derive a cap rate based on his/her desired return. Sophisticated investors usually have a return they want on their investments. This is commonly referred to as a cash-on-cash return, which accounts for the financing of the property. BOI allows us to derive a cap rate using our desired return.

By utilizing BOI, you can obtain the cap rate that should be used to compute the value of your offer.

In the example above, we calculate a cap rate that can be used to determine an offer for the property that will generate the desired return.

Based on the assumptions above (A-E), the Financing portion of BOI is 4.8% (75% financing * 6.4% mortgage constant = 4.8%) and the Equity portion to be 1.2% (5.0% desired return * 25% down payment = 1.2%). As such, in order to receive a 5% return on investment, the cap rate required is 6.0% (Equity portion of 1.2% + Financing portion of 4.8%).

When we compute the value/price of the investment choices using our required cap rate of 6%, we see that only property C will deliver the desired 5% return if we pay the asking price.


The proper use of cap rates can lead to better investment decisions.

For properties with low cap rates, we must ensure they are Class A or B+ and require no real repositioning. These properties should be bought as a store of value with the goal of holding it for a relatively long time.

By using the Band of Investment method, we can make offers that will generate the desired returns on our investment. When using cap rate as a measure of risk, rather than return, we can focus on developing better offers. These offers will account for the funding and activities necessary to reposition the property to be in line with the market in which the property exist.

The "I only buy x cap rate" is what slows down most people. Great metric yes, should be only determinate no. I've seen some properties that can be transformed into great deals with questionable cap rates. It's useful to me when looking at historical valuation.

@Bjorik Mutize

Great points everyone. You must admit there's a huge difference between a 17 CAP rate & a 5 cap? In one case you can operate normally & make a 17% return. In another you must do a value add & take additional risk to improve the cash flow, IRR & Properties value. Huge difference in that case!

Okay so lets have a discussion then on cap rates.

Those who are buying 4 caps multifamily and you have passive investors money in a syndication deal. 

What happens if your analysis of underwriting only comes HALF WAY true? Say you buy at a 4 cap and then blend it up to a 5.5 cap on the way to a 7 cap but nationally we have a downward economy on the cycle? Last downturn I saw rent growth stall, waiver of security deposit or half off 1st months rent or free rent. Investor owners did this to maintain market share to keep occupancy up to service their debt loads to stay afloat. When lots of landlord infight to keep occupancy the rents in the market can soften. In multifamily when property taxes, insurance, and other costs rise you do not get reimbursed by tenants like other asset classes so can eat into returns.

What about consumers hitting their debt ratio to income ceilings in ability to keep paying higher and higher rents per door?

I hear these days everyone and their brother is buying multifamily. I remember the last downturn when it took a real bath. Multifamily is not bulletproof investment like lots of syndicators are preaching these days. You can lose your butt in it just like any other asset class. Banks are easy to lend and buyers easy to buy.

On the retail side I like high cap unstabilized deals going in. Stabilized becomes really high cap rate for breakeven. Interest rates rise and sale market for stabilized softens by 50 to 100 basis points I can still sell easily and make a great profit. I have less competition because many do not understand the space on a deep level to be comfortable with it. They see risk but I know the potential but I am an expert in the space. 

This is just me being curious. I have been out of multifamily for a long time now. You see about as many syndicators in multifamily as you used to see seminar sellers for single family residential house flipping. It's rampant right now. Stuff in Atlanta at the bottom was a 12 cap in rougher areas that were D to F areas. Now the syndicators are putting packages selling off as C areas or better and buying at 6 caps. When economy goes down those marginal areas and tenant base will crater as they live hand to mouth. They take on debt in good economy and then fall apart with no reserves when down cycle happens.

I am glad everyone is doing so well with multifamily. I guess there are still deals out there but the real ones maybe 1 in thousands these days.       

@Kyle Marcotte BOOM! What an intro! 

I completely agree with you. Its funny because I was talking to someone at a MeetUp last week and this conversation came and the newbie debated me on the Cap Rate over a 160-unit deal we just closed on Houston. 

I had to educate the newbie about entry and exit cap rates and that these rates are dynamistic in nature.

Welcome to BP...

@Kyle Marcotte I agree completely with your point of view on cap rates and would add that something similar could be said for all metrics: they’re useful when taken all together and in conjunction with some construction knowledge in order to give a snapshot of the overall quality of a property, but no single metric reveals a whole lot about a property by itself. I keep all of my initial spreadsheets and like to look back at them a few years in. I’ll be the first to admit that many of my properties that looked great on paper have been WAY different in reality, but thankfully I’ve been getting more accurate over time. I have found that the lower the cap rate on purchase, the better overall return, because these properties are in better locations with more appreciation, less turnover, less issues in general, and more significant rent increases. I doubt I’m alone in this. Running numbers is important but it’s more important to be able to read what they’re telling you. For example a lot of beginners will see a cap rate that is very high for their market and think thats a good thing while more experienced investors will consider it as a red flag or an indicator that the property is undesirable for some reason: could be it is in a bad location, is in poor condition, will have limited appreciation, etc. which might be counter-intuitive for someone solely focused on getting a certain cap rate. Analyzing a property is more of an art than a science in my opinion.

I agree. But not for the reason you state. 

Unless you're buying some A+ tenant NNN deal, someone selling a "6 CAP" for them will not be a 6 CAP for you. Could be 5. Could be 4. Could be 7. Could be 8.

It’s why I’m so annoyed when someone insists on deep diving my financials before making an offer. What do my financials have to do with what you’ll see? I don’t have insurance. Will you? My blended management is about 4%. What's yours? I pay 4 cents KW. What will you pay. And even a rent roll won’t show you income. Will you keep the same occupancy levels? Quick turne over? Enforce late fees? Etc etc.  

So yes CAP is important. It's just the CAP you're given is normally bullsh*t

It's true that the going-in cap rate is often meaningless. In general, however, cap rates are useful for gauging market sentiment, and they're most useful for determining exit prices. For example, seasoned investors usually underwrite ~10bps of cap rate expansion per year. So if you buy a property in 2019 and expect to sell it in 2024, you would assume that cap rates would be 0.50% higher. 

Even though you're hopefully adding value, the property is still 5 years older. And if you assume that things will always stay the same or get better then you will have no margin of safety. That being said, you don't want to lose out on a deal because of 10bps in your underwriting. 

Originally posted by @Cody L. :

I agree. But not for the reason you state. 

Unless you're buying some A+ tenant NNN deal, someone selling a "6 CAP" for them will not be a 6 CAP for you. Could be 5. Could be 4. Could be 7. Could be 8.

It’s why I’m so annoyed when someone insists on deep diving my financials before making an offer. What do my financials have to do with what you’ll see? I don’t have insurance. Will you? My blended management is about 4%. What's yours? I pay 4 cents KW. What will you pay. And even a rent roll won’t show you income. Will you keep the same occupancy levels? Quick turne over? Enforce late fees? Etc etc.  

So yes CAP is important. It's just the CAP you're given is normally bullsh*t

Yeah but how your property is currently being run could tell me how much work I have in front of me to get it to where I want it to be. And let me know if I'm keeping that upside or am I paying you now for the honor of doing all that work after I close?