Clearing Up Confusion About Cap Rates in Multifamily Investing

Last night, I had a horrible time getting to sleep. I did exactly what I should not do before bed, which was look at my phone. I know - no devices after 9:00 pm, because it scrambles your sleep circuits. 

But I was excited because someone in one of my groups was asking a question about cap rates and I wanted to get back to them as soon as I could.

But then I could not get to sleep until 2:30 am, so I'm pretty bleary-eyed. Rather than drag myself over to my office after dropping the kids at school, I decided to come over to the local coffee shop instead, and that's where I am right now.

So, back to cap rates. Put very simply, a cap rate (short for "capitalization rate") is the same thing as the unleveraged yield on a property. In English, that means the return on the property if you paid 100% cash and had no mortgage on it.

You calculate the cap rate by dividing net operating income by the purchase price. Net Operating Income (or NOI) is what you get when you subtract all operating expenses from revenues. It's the operating profit before any mortgage payments or capital expenditures.

Cap rates reflect three things. First, they reflect the demand for real estate, which itself reflects the availability of debt. When interest rates are low, and debt capital is plentiful, cap rates tend to drop. This is called "cap rate compression," because the cap rates are getting smaller. Conversely, when interest rates rise and demand for property drops, cap rates rise (or "expand" or "decompress").

It's important to remember here that cap rates rising are a good thin for buyers and cap rates falling are a bad thing for buyers. (And the opposite is true for sellers.) That's because the cap rate reflects the return on the property, i.e., how many dollars an investor is willing to pay for $1 of NOI. A cap rate of 5% means buyers are willing to pay $20 for every $1 of NOI. A cap rate of 10% means buyers are willing to pay $10 for ever $1 of NOI.

The second factor behind cap rates is buyers' view of the particular market where the property is located. Markets with high demand from investors, because they are perceived a strong investments, like New York City or San Francisco, have lower cap rates across the board than markets with less demand, like Cleveland or Buffalo.

The last factor affecting cap rates is the age/class of the property. Newer, higher rent properties have less capital expense and renters with better credit, so they generally have lower cap rates within a market than older properties, with more capital needs and lower quality renters. Generally speaking, a Class A luxury building will have a cap rate approximately 1% lower than a Class B property in the same area. In turn the Class B property's cap rate will be approximately 1% lower than a nearby Class C property's cap rate.

In real estate groups, I see a lot of confusion over how to use cap rates in investing. Cap rates should be used to compare the return on one property to another. Cap rates allow you to determine the return independent of any financial engineering because it does not take mortgage debt into account.

The cap rate also gives you a quick and dirty way of determining whether a property is going to meet your investment objective.

However, I often see new investors ask questions like, "What cap rate should I pay in this market?" The question is asked as if, as long as you are buying at the current cap rate, the investment is a good one.

Since the cap rates are being set by other investors, this is a silly question. I'll explain this by way of analogy of buying a gallon of milk at the supermarket.

Imagine you went to the dairy section and asked a store clerk, "How much is this gallon of milk?", the clerk responded, "Those guys over there just paid $75 for a gallon of milk," and you then said, "Okay, as long as that's what they paid, that's a good deal. I'll pay $75 too."

Then, you went into another supermarket the next day, and the clerk told you, "Those other guys just paid 50 cents for the gallon of milk," and you said, "Okay, as long as those guys paid 50 cents, that's a good deal, so I'll pay 50 cents too."

It's a ridiculous analogy, but the point is, when investing in real estate, determining what is a good deal based on what others in the market are doing makes no sense. If there is a milk bubble and other people are paying $75/gallon because they believe milk will go to $100/gallon, it makes no sense for you to buy if you believe milk is really worth $4/gallon.

The point here is that you must make your investment decisions based on your return expectations and what you are willing to pay for the property. If the market currently values the property higher than you do, your response is to walk away from the property, not to buy it anyway, because everyone else is caught up in the frenzy.

As Warren Buffett famously said, "Be scared when others are greedy. Be greedy when others are scared."

Right now, other people are very, very greedy when it comes to real estate. You should be very, very scared.