Cap Rate on Multi-Family Property
Real Estate Agent 路 Member since 2019 路 167 posts 路 72 votes
What is a good cap rate on a 20 unit apartment complex close to 2 universities in a highly desirable and rentable area in Nashville, TN? Is 6% low, 8% average and 10% high? Forgive my ignorance but what is that based on, yearly gross rent? More specifically, at 20 units and they each rent for $1500/mo, that is $30,000 total monthly and multiplied by 12 equals $360,000/yr gross rent. Is $4 mil purchase price at a 9% cap rate good? Being in one of the most desirable neighborhoods and rental areas of the city, how low could you go on cap rate or said a different way how high could you go purchase price?
@Mark Gliebe
1. Cap rates are basically a measure of what the market value is for a property .. people use them to compare commercial properties mainly bc they are rarely similar . eX you can compare a 12 plex vs a 30 unit.
2. Specifically Cap rates are defined as the Net Operating income / price of the asset .
3. So it's really important to understand NOI ... NOI is gross rents minus total expenditures ( not including debt service ) ... NOI is the number that you want to care about MOST ... with MFH it's important to understand all of the costs .. like water bills , electric bills , maintenance, tax bills, trash service etc . Once the NOI is properly calculated and most importantly, Verifiable then you can think about Cap rates/ price.
4. Lastly you need to think about how the property will be purchased .. Ex. Cash, financed , how much down , what terms .. etc that will dictate what you can afford cap rate wise.
Another point about Cap Rates, they are also a measure of ability to raise the price of the property for exit. To double the market value of a building you need to "decrease" the NOI at a proportionate level which is significantly harder to do at a 10% cap than a 4% cap. This sounds weird but in reality you don't actually decrease the NOI, you have to increase the value of the building so that the cap rate falls. The changes in market value are not linear when you work with cap rates so always keep your strategy in mind when you are picking a property.
Neil,
It comes down to improving the operations of the property. I.e. improving the NOI. Now I said you need the NOI to "fall" however that is in relative terms to the value of the property. Let's lay out a few examples of how the value can be increased.
Example 1
You have a 50 unit multifamily property in an area where it is difficult to build multifamily property for anynumber of reasons. However the city would like to increase the available housing stock in that area and you negotiate with them to allow you to increase the density on your property to 70 units. You have now increased the value of the property with out changing the revenues because of the potential future revenue increases that are now possible.
Example 2
You have a 10 unit retail property with an average life of lease at 6 years in an area that is rapidly redeveloping. Your rents will likely not be keeping pace with the rents in the surrounding areas. Your NOI will be "falling" in comparison to surrounding retail properties however the value of your property will still be impacted by inflation. Thus lowering your cap rate.
Example 3
You have a 25 unit multifamily property that you purchased at a 10% cap rate for 5 million dollars you added 1 million in property improvements and increased the rents by 10%. This would be a situation where you added value and lowered the cap rate at a disproportionate rate to the value increase in the property. It's a weird example and usually isnt the norm.
Most of the falling cap rates come from market influences or market + value add. This is the primary way that investors make money in high cost markets. Operations isn't usually a reliable source of profits for these projects.
@Michael Heisterkamp can you clarify for a new investor, how can you increase the value of a property to lower the cap rate if the value of the property is calculated by using the cap rate? It's making my brain explode
The prevailing cap rate of a certain area (certain sub market) is a reflection of investors' sentiment in that market. If investors are bullish about a certain market they will bid up the price. When investors bid up the price, they are saying that they are now willing to pay more for a given dollar of NOI. For example, investors might have been paying $10 for every $1 of NOI in the past (i.e. 10% Cap) but because of above average economic growth in the area, investors are now willing to pay $12 for every $1 of NOI (i.e. 8.3% Cap). This is an example of cap rate compression. The point here is Cap Rate is determined by investors (i.e. by the MARKET). Property owners can not lower or raise cap rate.
So how do you increase the value of your property? Well let's look at the formula... Value = NOI / Market Cap Rate. Just based on the formula an increase in Value can be achieved by either increasing NOI or decreasing Market Cap Rate or BOTH. But wait, we have stated earlier that Cap Rate is determined by the market and property owners can NOT lower or raise cap rate (i.e. property owners can NOT control market cap rate). So property owners are left with manipulating NOI as an option to alter Value. The fact is to increase Value, about the only thing you can do is increase your NOI! How do you increase NOI? Raise revenue or reduce operating expenses or both.
You might run into explanation that seems circular - value is calculated based on cap rate but cap rate is calculated based on value, it's like watching a dog chasing its own tail over and over again ... at some point your brain will explode :-) As stated above, the breakdown in the logic is the fact that some people think they can alter and calculate cap rate, this is incorrect. Cap rate is given, it's determined by market consensus (i.e. investors). You can obtain cap rate from local commercial brokers, property managers, bankers, etc.
So the statement "...increase the value of a property to lower the cap rate.."does not make sense! You can not lower the cap rate in a given market.
Cheers... Immanuel
Also, no one mentioned INTEREST RATES.....if money is cheap and abundant, it will depress cap rates. Right?
Also, current Cap rate does not take into account "UPSIDE". IF the current landlord hasn't raised the rents in 20 years, because they just wanted stability and zero turnover, there could be tons of upside once the rents are brought to current market, so what looks like a crap deal because it is only 3% current cap rate, may actually be able to achieve 6-8% cap rate in a fairly short time with aggressive management.
@Immanuel Sibero thank for this brain-relieving lesson. So this means that in any given neighborhood, there is a prevailing cap rate that the investor has no control over. And correct me if I am wrong, but the property neighboring my own property will have the same cap rate as mine. And these are the only things that can be done to change the value of the property:
1. Hope market conditions change (improve) in the neighborhood, in which case buyers would be willing to pay a premium for that NOI in that area, hence value goes up.
2. Increase revenues and/or decreasing expenses, causing NOI to increase and subsequently, the value to increase.
3. Creating POTENTIAL for increased revenue in the future, i.e. building add ons and improvements that result in a market value increase
Am I missing anything?
@Michael Heisterkamp and @Isaac S. Thank you for these examples. It seems that there are some silent cap rate factors at play here that people are forgetting . Inflation and interest rates. This an exciting puzzle
@Michael Heisterkamp still trying to wrap my head around your third example. Need to ruminate on this one a bit more.
@Neil G. Don't feel bad about it. It is a rather edge case that rarely expresses itself in the market. Just look at it this way, you spend money on a property that is higher than the expected return to rent. However at the same time it increases the market price of the property at a higher than expected value. Again, let me emphasize don't worry too much about it as it is an edge case.
The focus I was trying to convey, and ended up doing rather poorly I must say, was that low cap rates are not necessarily a bad thing. It all depends on what type of investing you do.
@Neil G. We are essentially saying the same thing. You can increase the value at a static NOI by cap rate compression. The other way to increase the price is to have a static cap rate and increase NOI.
My mind tends to think on multiple planes at once and it sometimes causes me to make jumps that I assume are logical.
@Immanuel Sibero thank for this brain-relieving lesson. So this means that in any given neighborhood, there is a prevailing cap rate that the investor has no control over. And correct me if I am wrong, but the property neighboring my own property will have the same cap rate as mine. And these are the only things that can be done to change the value of the property:
1. Hope market conditions change (improve) in the neighborhood, in which case buyers would be willing to pay a premium for that NOI in that area, hence value goes up.
2. Increase revenues and/or decreasing expenses, causing NOI to increase and subsequently, the value to increase.
3. Creating POTENTIAL for increased revenue in the future, i.e. building add ons and improvements that result in a market value increase
Am I missing anything?
Yes market cap rate can differ from one submarket to the next within a metro area. In DFW metro for example, market cap rate is generally lower in the north side since it's the path of progress. Also within a submarket, cap rate generally varies depending on the property class. Class A being the lowest cap rate.
....And correct me if I am wrong, but the property neighboring my own property will have the same cap rate as mine....
This is a frequent source of confusion.... "market" vs "property" cap rate. The cap rate you're referring to in the above statement is the "property cap rate". Yes, every property has its own cap rate and it may or may not be the same as the "property" cap rate of the property next door even though the property next door may be identical. Property cap rate depends on how the property is managed and how much was paid for it, so it's different for each property and can be easily manipulated (just look at loopnet.com). This cap rate can be controlled by the property owner. But this cap rate ("property" cap rate) is not the cap rate potential buyers use to calculate value so it's irrelevant and not very useful. As indicated before, in valuing properties potential buyers use "market" cap rate which is determined by the market.
Your three examples of increasing value are correct. It really doesn't matter what you do, if your NOI increases then value increases (assuming everything else being equal). It is just that simple.
Cheers... Immanuel
Hey Mark,
CAP RATE= NOI/PURCHASE PRICE OR NOI/CAP RATE= PURCHASE PRICE
NOI= GROSS INCOME - EXPENSES
So, you should look for the NOI of the deal you're currently analyzing and divide by the purchase price to get your cap rate OR if the listing agent provided "their analyzed cap rate" (which is incorrect half of the time" i would do NOI/CAP RATE SHOULD EQUAL PURCHASE PRICE.
How do you know you're buying at a "correct" cap rate?
1. Look at sold comps in the exact same condition within the last 6 months
2. Contact commercial brokers and ask them what the zip code cap rate is
3. Contact commercial property appraisers and ask them what the area cap rate is
These will most likely all vary and you will have to come up with an average.
From experience big cities are going around 4-6%.
Now, cap rate is really just a way to determine the value of the building, at the end of the day what's really important is that you're cash flow positive after expenses and debt service.
Hope this helps and good luck!
@Immanuel Sibero @Michael Heisterkamp one thing your explanations still differ on is the idea that you can increase the value of the property to decrease the cap rate. Anyone care to clarify this discrepancy?
When it comes to the idea "that you can increase the value of the property to decrease the cap rate", I don't have a different explanation, I just think that statement doesn't make much sense. One of the main objectives of investing in a property is to increase value. So if you are already able to increase value then why do you care that cap rate decreases or increases? You've already achieved your objective. Besides, if you're talking about "market" cap rate you CAN'T increase or decrease it anyway because it's determined by the market.
Cheers... Immanuel
@Michael Heisterkamp can you clarify for a new investor, how can you increase the value of a property to lower the cap rate if the value of the property is calculated by using the cap rate? It's making my brain explode
The prevailing cap rate of a certain area (certain sub market) is a reflection of investors' sentiment in that market. If investors are bullish about a certain market they will bid up the price. When investors bid up the price, they are saying that they are now willing to pay more for a given dollar of NOI. For example, investors might have been paying $10 for every $1 of NOI in the past (i.e. 10% Cap) but because of above average economic growth in the area, investors are now willing to pay $12 for every $1 of NOI (i.e. 8.3% Cap). This is an example of cap rate compression. The point here is Cap Rate is determined by investors (i.e. by the MARKET). Property owners can not lower or raise cap rate.
So how do you increase the value of your property? Well let's look at the formula... Value = NOI / Market Cap Rate. Just based on the formula an increase in Value can be achieved by either increasing NOI or decreasing Market Cap Rate or BOTH. But wait, we have stated earlier that Cap Rate is determined by the market and property owners can NOT lower or raise cap rate (i.e. property owners can NOT control market cap rate). So property owners are left with manipulating NOI as an option to alter Value. The fact is to increase Value, about the only thing you can do is increase your NOI! How do you increase NOI? Raise revenue or reduce operating expenses or both.
You might run into explanation that seems circular - value is calculated based on cap rate but cap rate is calculated based on value, it's like watching a dog chasing its own tail over and over again ... at some point your brain will explode :-) As stated above, the breakdown in the logic is the fact that some people think they can alter and calculate cap rate, this is incorrect. Cap rate is given, it's determined by market consensus (i.e. investors). You can obtain cap rate from local commercial brokers, property managers, bankers, etc.
So the statement "...increase the value of a property to lower the cap rate.."does not make sense! You can not lower the cap rate in a given market.
Cheers... Immanuel
Immanuel got it right.
Cap rates is a measure of risk/return for a given property in an area or location or sub-market.
For example, in Cincinnati area, we see the following cap rates:
A area - 4% to 5% cap
B area - 5% to 6% cap
C area - 6% to 7% cap
D area - 8% to 10% cap
F area - 10% -12% or more cap
So, given two buildings with the same economic or financial performance (say both produce a Net operating income of $100Kyr), one will pay $1M ($100K divided by 10% cap) for that building if it's located in a D area but pay $2M ($100K divided by 5% cap) for it if it's an A area. Why? The A area has lower risk and therefore the investor is willing to pay a higher price and willing to accept a lower return.
In addition to what Immanuel said though, cap rates will also depend on the # of units of the building in a given area. For example, smaller apartment buildings (5-30 units) will command a higher cap rate than larger apartment complexes (31 units and up specially 100+ units and up).
So if they're in the same area, a 30-unit building might be worth 5% cap but a 100+ unit building might be worth 4% cap.
Hey Mark,
You shouldn't just go on the Cap and Purchase Price because Cap Rates are dynamistic in nature and frankly subjective by market and asset class. Price is what the Seller it's worth and what the Buyer is willing to pay for it. Not surprisingly, this is always an interesting point of contention.
As a result, you should focus on YOUR true cap!
What are your project figures?
What are your investors looking for or if you are the sole purchase: what are you ok with in terms of ROI?
What is the play here? Value-Add or is it already stabilized?
Who is your primary demographic profile? Students or mixed tenants. Student housing is a different animal.
Getting a full picture of why this "property" and its story will allow you to make a more informed decision.
@Onaje Barnes
Thats a very good explanation. Very technical. I would add one extra point. You mentioned college... students tends to increase maintenance expenditure. Check if there are students renting the place. If so, calculate a bit higher maintenance cost to get to your NOI.
@Immanuel Sibero Thanks for providing such a clear and succinct explanation.
@Angelica M Garzon Thanks for providing an actionable plan for getting the cap rates in an area. I'm new to analysis and want to get my feet wet in some market research.