Still Confused About Cap Rate? Here’s an Experienced Investor’s Explanation

by | BiggerPockets.com

There are a few concepts in real estate investing that are particularly challenging for folks. One of these concepts is the capitalization rate (cap rate). I’ve written on this subject before, but judging by some of the questions on the forums, it’s time for a review. And truthfully, it’s a confusing topic.

What Is Capitalization Rate?

A common misconception is that the cap rate is a property-specific metric. This is not quite right. While the coefficient that is the cap rate can indeed be used to evaluate the performance of a specific asset, what it really does (the origin of the number itself) is illustrate the general behavior in the marketplace as a whole as it relates to risk/reward appetite. Cap rate is a market-driven metric; it is not asset-specific.

Let’s Take a Step Back

Valuation mechanics are easier to understand in the SFR space. In order to assess value of a house, we perform something called comparative market analysis (CMA). As part of CMA, we look to the closed comparable sales (comps) and make adjustments to the price to reflect the condition and amenity package of the subject.

Related: How I’m Earning an 8% Cap Rate With My Vacation Rental

For example, let’s say our subject is a 3/2.5 with a garage. Let’s say that one of the comps, which was a 3/2 without a garage, sold for $110,000. Another comp, which was a 3/2.5 but without a garage, sold for $107,000. What can we glean based on this information?

sell-or-rent-house

Well, for one thing, all things being equal, it seems that in this neighborhood, a garage is a more valuable feature than a half bath. Also, based on this information, we can estimate that our 3/2.5 subject, which has a garage, is likely to be valued more than either of the comps, which had either the half-bath or the garage.

Such is the rationale. The important thing to note here is that what we are comparing is the amenity and condition. Why? Because amenity and condition is what people are buying when purchasing an SFR.

Income Property

When we discuss income property, however, we must understand that what people are buying is the income (at least in the most basic sense). Therefore, it makes sense that the value is somehow pegged on income.

So, what do we need to do in order to establish the value of multifamily? Well, it’s not that different in concept from the SFR. We are going to complete a market study in order to understand what people are paying for similar property—this constitutes the market. However, important to note is that in this case, since we know that what they are really buying is income, we are less interested in the relationship of price to amenity, as in SFR space, and more interested in the relationship between that which people paid and the income that their money was able to buy.

Cap Rate

In the static sense, the capitalization rate is simply a coefficient which represents this relationship between price and the income this price buys. In each one of these comps, there is a specific rate of return that was projected at the time of acquisition. 

Cap rate, therefore, is just a formula:

Cap Rate = Income/Value  

(Where income is NOI.)

This is what you’ve read in the forums and articles on BiggerPockets. And this is not wrong—the formula is exactly correct.

The trouble is in how you use it. Understand: Cap rate is the measurement of market more than anything else. Why? Because we must look at all of our comps as a whole to extrapolate the mean. For example, let’s say you’ve analyzed 10 closed transactions and discovered that the investors paid in the range of 7%-7.5% capitalization rate for all of these properties.

Related: The Investor’s Complete Guide to Calculating, Understanding & Using Cap Rates

What this tells you is that it takes a 7%-7.5% rate of return to convince investors to deploy capital in this specific marketplace for this asset class. Anything less would require paying higher dollars for this revenue, and this is deemed too risky. Anything more would be welcome, obviously, since it outperforms that market. Cap rate is a measurement of the market as it relates to risk and reward.

What Can You Do With That?

Well, just like you can look at a house and decide that it’s worth $250,000 and not a penny more, you can look at a revenue stream and decide that it’s worth XYZ% return and not anything less. Cap rate tells you what other investors are thinking. Again, cap rate is a market statistic. You, however, have a head on your shoulders and are allowed to either agree or disagree with the market.

The money in real estate is made in the delta between the market valuation and your strategic positioning. When you sell, you have to abide by market conditions. However, in order to build that delta you have to buy right. And to buy right, you may or may not be capitalizing value at all.

Hope this helps a little. Have fun, boys and girls! 

Still have questions? Comments?

Leave them below!

About Author

Ben Leybovich

Ben Leybovich has been investing in multifamily residential real estate since 2006. His area of expertise is creative finance. Ben works extensively with private as well as institutional financing. Ben is a licensed Realtor with YOCUM Realty in Lima, Ohio. He is also the author of Cash Flow Freedom University and creator of a cash flow analysis software CFFU Cash Flow Analyzer.

18 Comments

  1. Luis Roa

    1) When you say “Let’s say that one of the comps, which was a 3/2 without a garage, sold for $110,000”, I think you meant to say “Let’s say that one of the comps, which was a 3/2 with a garage, sold for $110,000”

    2) instead of one calculating the cap rate (as in your example, where you say “let’s say you’ve analyzed 10 closed transactions and discovered that the investors paid in the range of 7%-7.5% capitalization rate for all of these properties”) isn’t the rate published by the local financial institutions (banks, etc)?

  2. Curt Smith

    Tnx Ben, for my own spread sheet I only track purchasing cap rate, I never consider appreciated (value) some years down the road. I only care about the cash I have into the deal.

    I suppose one could use dropping cap rate over time accounting for appreciated value as a metric that your rents are not keeping up, time to re check market for rents. Or your expenses are rising. Either way I see the slight value of calcing real time cap rate accounting for actual recent expenses, rent, appreciated value… Sell at some lower cap rate. 🙂

    • Andrey Y.

      You are the exact opposite from Grant Cardone. He states that he doesn’t care about the cap rate. Its one of the last metrics he considers (if at all). To him.. gestalt/gut feeling, do I like this apartment, what kind of financing can I get on this deal, location, etc. play a more pivotal role.
      I sort of agree, buying via cap rate seems silly, but I am totally large multifamily newbie. What I am good at is earning >$200/hr in my W-2 job, which I hope not to have to do for more than a decade 😉 Question is, will real estate ever give me those kind of returns? But, I digress.

  3. Patrick Liska

    Thanks Ben for posting this article. I’ve tried explaining that to some posters to try and let them know that CAP does not mean that’s what you will make, it’s a performance indicator based on the area. the only way i feel you can gauge the profitability of a property for each person is through COC. depending on how much money you put in, this will tell you your rate of return on that investment. For each person that will be different, the more money in personally, the less your return amount will be.

  4. Erik Nowacki

    Ben,

    Good article! From my perspective, the CAP rate has two components, a market component and a property component. I invest in apartments in San Diego and Memphis, two very different markets.

    In San Diego, the CAP rates are ridiculously low, which is great for values and the return on your NOI increases. In Memphis the CAP rates are quite a bit higher, which is great for cash flow but harder to force the valuation higher. These two markets are a good illustration of the market component of the CAP rate.

    After determining the general market CAP rate for the specific area of the building, I would make adjustments for the class of building (A, B, C or D). An A class building commands a lower CAP rate than a C class building. Then, I would make adjustments for the occupancy of the building. Yes, a low occupancy would result in a lower NOI and thus a lower valuation when multiplying NOI by the CAP rate; however a low occupancy indicates a potential problem, so I would adjust the CAP rate up.

    I see the CAP rate as the risk premium for investing in multifamily properties, so anything that makes my return riskier should demand an upward adjustment of the CAP rate. Another method would be to use the market CAP rate and adjust the purchase price by certain amounts to account for vacant units, repairs, class of apartments etc.

    Happy Investing

    Erik

  5. I found the term “cap rates” confusing till someone used the term as a complete phrase….”income capitalization rate.” Or how many years you have to collect gross rents on this property until you match the capital you would invest to own this property and capture this income. This is the income to capital employed ratio or starting point an effective rental operator tries to improve through renovation, rent increases and better management.

  6. Benjamin Ficker

    My issue with the cap rate, on 1-4 unit properties, is that the number is so easily manipulated. A guy shows $400 in maintenance on a tri-plex. Actually, it was $400 in parts but he did the work so he won’t count that cost. NOI shows higher, better cap rate. On those types of deals, we only use the projected caps based off of our assumptions for repairs, etc.
    On commercial financing they have their assumptions they will make on expenses and it is more reliabel.

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