3 Things Real Estate Investors Must Know About Multifamily Cap Rates

Cap rates (or capitalization rates) are the cornerstone of valuing multi-family real estate.

In this short blog post, I’m going to walk you through what a cap rate is, how to use a cap rate, and where to find cap rate data.

Let's get right into it.

1. What a Cap Rate Is

A cap rate is the ratio between the NOI (net operating income) of a property and the property's value. So essentially, it's how much a buyer is willing to pay — or how much the market is willing to pay — for each dollar of NOI that the property produces.

A common misconception is that a cap rate is a multiple. It's not a multiple but an inverse of a multiple. Let me show you what I mean.

If you're a fan of the TV show Shark Tank or Dragon's Den, you'll often hear the sharks talking in terms of multiple. So they'll say, “Okay, you have x revenue so I’m going to pay you a 10x multiple on that and that's how I’m going to arrive at the valuation of your company.”

Cap rates are a little bit different. The higher the cap rate, the lower the multiple paid on the NOI. The lower the cap rate, the higher the multiple paid on the NOI.

For example, a 5 cap or 5% capitalization rate equals a 20x multiple. But a 10 cap (or 10% capitalization rate) equals a 10x multiple. Basically, the market is paying more for every dollar produced of NOI for the former property. All you have to do is to keep in mind that the lower the cap rate, the more paid for each dollar produced of NOI for that property.

2. How to Use a Cap Rate

Now how do we use cap rates in commercial and multi-family real estate? Basically, we use the income approach. And the income approach formula is NOI divided by your cap rate equals the value of the property.

For example, we have a property that produces 1 million dollars of NOI and we have a cap rate of 5%. All we do in this case is take the NOI of 1 million divided by the cap rate of 5 percent. That gives us a valuation for the property of 20 million dollars. Commercial property is valued based on the income the property produces. Now the cap rate you're going to use is going to vary based on the location and the class of the property. So a Class A property is going to be different from a Class C property, etc. But generally speaking, when we're valuing property using the income approach, we just take the NOI divided by the cap rate and that's going to give us the value of the property.

3. Where to Find Cap Rate Data

You often hear people talking about market caps. What’s a market cap? It's basically the prevailing cap rate at which properties are trading in a given market. Let's say you have a handful of properties. They've all traded somewhere between a 4.5 and a 5 cap. So you may have a market cap of 4.75 or 4.8 — somewhere around there. So you know as a buyer that the market is valuing the NOI produced by these properties at a 4.75 (thereabouts) cap rate.

Where do you find this data? Major brokerages will release cap rate reports. Major analytics firms will also release reports on a monthly, quarterly, semi-annual, or annual basis. These brokerages and analytics companies are keeping track of the market. They're monitoring all the different sales in the market and they'll often include projections for where they think the market is going. So if you’re a buyer entering a market — or if you already have properties in that market — it's always a good idea to keep track of where the major brokerages are placing cap rates and where they see them heading. After all, since they're the ones working with both buyers and sellers, they really have a good pulse on where that market is going.