What is minimum for good cap rate on a rental property?

23 Replies

New to the rental property investing game and I’m just trying to determine criteria to analyze deals more efficiently. What should be my baseline for cap rate on a rental property? The areas I’m focusing on investing in are Providence Rhode Island, Worcester and Fall River Massachusetts. Thanks in advance

I am relatively new to the multifamily sphere as well! I know cap rates are generally used for commercial properties (above 4 units) and the cap rates really depend on the asset class and your market. 

From what I have learned so far, I would specify what type of asset you are looking for and then see what properties are trading for or ask a broker in that market. 

@Reggie Desir it’s really related to the risk and your desire to invest vs. the supply; if you set your cap rate minimum too high you’ll never find something to invest in, in this market.

For an “A” area these days I feel 5% is a good rate to aim for, but plenty of people are buying in those areas at much lower rates so if you’re looking there you may need to go lower as well.

For a “B” area I currently like a 6% minimum cap rate and for a “C” area I like 7 or 8% depending on how bad the area is.

It also depends on the property, for example a property requiring a substantial rehab is going to need a higher rate even when stabilized just to compensate for the additional risk of the rehab.

Conversely, for a property that is turnkey and ready to go on day 1, I might be willing to except a lower cap rate - especially if it’s a newer property without a lot of deferred maintenance.

Another way to look at cap rate is, it’s the percentage of return you would receive annually, if you paid all cash for the property. So a cap rate of 10 would take 10 years. A cap rate of 5,  20 years. Some are content with having their money tied up in a property with a low cap rate. Others want the velocity of their money to be faster, so they can re-invest it.

Someone more snarky than me might say "there's no such thing as a "good" cap rate, cap rates have nothing to do with return." So while the first part is technically true, we all know what you're asking and are looking for. 

The best way to answer your question is to network some local investors/brokers/lenders and see what they are seeing/buying. That will give you a good sense of the market. It's not so much that you pick a target cap rate and you find a property to match. Instead, learn the market cap rate range, and see if that aligns with your risk tolerance and works with your strategy. You may decide you'll need to move up on the risk curve to get the return/cap rate that you're looking for. But still don't judge a deal just on cap rate alone. 

 A property purchased at a 3% cap rate can have a significantly higher cash on cash and total return than a property purchased at an 8% cap rate. The opposite can also, and often is, true. 

If you buy a 5 unit that is 40% occupied, at a 3% cap, but you are able to lease up the other 3 units at significantly higher rents, raise rents on the two renewals, you could be operating at a 7-8% yield on cost (or cap rate), with a 10%-+ cash on cash return. These are rough numbers, not exact.

Buy at an ~8% cap rate, but two tenants disappear after destroying their units. Now you could be operating at a 4% yield on cost, or worse.

Higher cap rate = higher risk low investor demand. Lower cap rate = lower risk higher investor demand. 

In a perfect market risk = return.

Now the trick is to identify where the market is inefficient at pricing risk, and exploit it. However to do that, you do need to know your baselines, how to operate, and be confident in your execution. 

Best of luck! 

Cap rates depend on the type of asset your are targeting. That being said, cap rate should not be the only metric you look at when analyzing a deal. Metrics like IRR, cash on cash, GRM, are better tellers. For me, a cap rate is good for a quick gauge on what they property is trading at but I'll dig into many other metrics when I'm underwriting a deal.

@Reggie Desir

I agree w/ most of the reply's that do not just look at CAP rate to determine if something is a good deal. Make sure you get actuals on the property because everyone is listing their numbers with proforma numbers and they can be very unrealistic. If you have never owned any commercial real estate before you are probably going to need to put more money down. You are going to want to talk with a bunch of local banks and credit unions to see if they will lend to you. A loan broker might be able to match you with a lender especially since you have no experience. Welcome to the game it can be life changing.

Good Luck!!

@Spencer Gray

Based on some of these online calculators I’m hovering around 9-10% cash on cash return if I use the example of

135k down payment

62k gross income

26k annual mortgage payment

21k operating expenses

3% vacancy loss

Thanks for the feedback

I’m horrible at math but 9.8% is the number I got when I plugged in all these numbers.

@Reggie Desir

Are those proforma #s?

Gross Income   $62,000
Vacancy                  -3%   (Seems low but I have no idea about this market)
Expenses       -$21,000

NOI $39,140

Dividing NOI/DS gives you a DCR of 1.5. Most lenders want to see a DCR of 1.25 so your good there. Make sure you also want to plan your exit from the property. Is there any way to raise the NOI? You want to do your best to raise the value of the building because that's what's going to give you your biggest return.

Are you managing the building yourself or are you getting a property manager? The expenses seem a little low make sure when you get the T-12 look over the expenses. Make sure they did not move a lot of the expenses to CapEx to make their operating expenses look better.

The reason I am asking the questions is to make sure you are thinking about these things.  Just because I am asking questions does not mean I think it is a bad deal.  Trust but verify. 

@Nick Robinson

I appreciate all of the questions honestly. It’s making me think of it all from multiple angles. Because it’s so early in my investment career I don’t have the eyes to catch things that an experienced investor would. So any and all questions and perspective is greatly appreciated.

This particular property is being managed by a property management company. I believe it’s around 2k annually.

@Reggie Desir , hi.

I'm going to repeat something I said in a recent post on a similar topic: CAP rate isn't really relevant until you get well over 50 units. Probably more like 100. the idea behind it is to give a high level analysis of how investment A compares with investment B....for example, an apartment complex vs. a diversified stock market portfolio. The formula for CAP rate includes all operating expenses such as taxes, insurance, maintenance, management, capital expense (CapEx) reserves, lawncare/snow removal, etc. You must fully account for all expenses for it to be a "true" comparison, which makes sense because a stock market portfolio doesn't take any maintenance at all, other than perhaps once a quarter you check on it and rebalance as necessary. If you plan on donating your time for maintenance and management, that will throw off your numbers.

One of the more commonly touted strategies on BP and other REI sites is boosting value by increasing Cap rate. That isn't going to work on a 5-unit. You can still run a CAP rate because the formula remains the same, but just be aware that no other investor or lender is going to take that as the true value of the property; rather, the value will be based on comparable sales.

Cash on cash / bottom line cash flow (after debt service and all expenses) is a more accurate analysis for smaller multifamily properties.  

@Reggie Desir , I will add that cap rate is also only truly relevant to fully stabilized, no additional upside properties.  If there is any area of forced appreciation (value-add component) the cap rate starts to become less and less relevant.  The extreme example is getting to development deals, where you are buying raw land.  No income, only expenses.  But the FUTURE potential income drives the value in that land.  

@Anthony Jeffers , price per door seems to be a much more common value assessment, since most small properties are run by mom and pop operators, and therefore NOIs are all over the place. It isn't until you really start cresting the 50 unit properties, but, as Erik mentioned, moving into the 100+ that you start to get more professional, consistent operating teams onto properties, where NOI is the biggest indicator.

That's not to say NOI and market cap rates aren't assessed, but they are one factor of several that effect value.

Hi Reggie, happy to connect if you'd like to discuss investment opportunities in Worcester! I specialize in multifamily here and am happy to share my thoughts on the city and keep you in mind for deals that fit your investment criteria. 

Be careful on CAP rates, especially for small multifamily. They are usually published by the listing real estate agent and don't include all expenses. I have seen them not include things like management, lawn care or even repairs. They will say, "the owner was doing those things", implying there is no cost if the owner does it. This is less of an issue with large multifamily since they are run more like a business and you have real operating statements that account for all expenses.

I know people say that lower CAP means lower risk and higher demand, but that is not always true. CAP rate can be lower due to the property being overpriced. CAP rate can be higher due to the property being underpriced if there is opportunity to raise rents.

It is best to put the property into a deal analyzer and determine cash flow and cash on cash return. You plug in all expenses, including management, repairs, etc. If the expenses are supplied by the listing agent, verify they seem correct. For example if someone told you repairs are $0 per year, that is not reasonable. Most deal analyzers have default of something like 5% for repairs and 8% for management. Obviously if the property is in bad condition, put in a higher number for repairs. Income should also be verified. Make sure advertised rents are in line with fair market rents. If they are lower, you may have future opportunity to raise rents and increase cash flow. They are average or high, that could be a sign of inflated numbers.

Final thing to consider is that financing can play a big role in profitability of a rental property. One to four unit properties can be purchased with conventional financing. These programs have great interest rates and long term fixed rate. When you get into 5 unit properties, you need commercial loans. That is going to be a higher rate and shorter fixed term. CAP rate looks at an all cash purchase equation. Once you figure in financing, the numbers look different.

It honestly varies on the property, the location, etc. The capitalization rate is a helpful metric to use when shopping for a rental property. But should not be the only formula used when trying to figure out how valuable a rental property can be. You should not base your final decision regarding a property purchase entirely on cap rate. Just keep in mind that the cap rate doesn’t take into consideration the depreciation/appreciation of a rental property, which plays a major role in determining the return on your real estate investment. Also, it does not account for the way of financing your property.

@Anthony Jeffers , correct. Lenders/experienced investors will typically use comparable sales to determine how much they will lend you vs. using CAP rate to determine LTV. Remember: if you default the lender has to turn around and SELL it, and usually a default on a loan indicates the property is being run poorly and may be in a shambles or disarray. Their last desire is to own the property and manage it, regardless of how awesome the CAP rate is. Your boosting NOI $10,000 annually on an 8 CAP 10 unit complex won't increase the value to $1,100,000. Maybe among smaller Buyers some will look at it that way, but traditional lenders or institutional investor won't. They're concerned with, "If Anthony drops off the face of the earth, what can we sell this for quickly?" And since most small Buyers are going to need traditional lenders or institutional investors underwriting their purchase, they too will have to use those same guidelines for all intents and purposes. Which is why you want to look at bottom line cash flow as I mentioned in the final paragraph above.

@Reggie Desir , see the above paragraph. Per my original post, you can run a CAP rate analysis for your own personal, internal purposes comparing apples to apples on anything from a SFH up to a medium size MF as long as you properly account for all expenses, including your own donated labor, equipment and materials. But to reiterate: no lender or large investor who will underwrite this venture will value it that way. I learned this the hard way as I was running CAP rates for months to find good deals. I finally found one (20-unit MF complex, price $1,1 million), got it under contract, then the lender said, "Nope, comps won't support it." Institutional money wouldn't touch it either. Too small of a fish to get them excited.

I know, I know, I know...many folks on BP preach CAP rates and forced appreciation, etc. If you could dig into their smaller deals and see how they really happened, my guess is you would find CAP rates are a second or third tier concern behind comps. Either that or they have access to vast quantities of private capital from investors who only care about cash flow and the Buyer finds something that cash flows well that also runs a decent CAP rate analysis. This leads to conflating the two concepts and the Buyer thinks it's all about the CAP rate rather than the cash flow. The two are often positively correlated. Anything 9 CAP+ should cash flow well as long as it's not overleveraged or in terrible condition, but it's the cash flow, not the CAP rate, that makes the deal happen with these smaller properties.

My experience in the world of MF says anything below 50 units is considered "small".  Medium is somewhere between 50 - 100 units.  Over 100 units you're talking large....maybe 200 units in some markets.  Anything between 5-10 units is going to be straight comps and may be based on using multiples of single duplexes that have sold in the area.  Unless your market is considerably different than mine, 5-10 unit buildings rarely come on the market, so the appraiser will take 2 - 4 plexes and multiply by the number of units to get a reasonable guestimate of value.

As always, this analysis is brought from my market perspective and experience.  Others may feel differently or their markets may need numbers adjusted.  I'm from a Mid-West town of 170,000 people where real estate is relatively inexpensive compared to the coasts and other big cities like St. Louis or Indianapolis.  The thing you can buy here for $1.5 million might sell for $3 million elsewhere, and that changes the game with lenders.