As an investor in real estate, you’ll be interested in purchasing a property that can bring you returns. You expect these returns to increase over time, or at the most, hold and not drop. One way to measure the earning potential or value potential of a real estate property is to study the cap rate of the asset.
Definition of cap rate
Cap rate, more formally called Capitalization Rate, refers to the rate of return yielded by an asset during a particular period of time. Typically, the cap rate refers to the returns generated in a span of one year.
Calculating cap rate
Cap rate is calculated using the following formula:
Net operating income: The Net Operating Income of a real estate property can be calculated using this formula:
Rental Income + Other Income – Vacancy Loss – Operating Expenses
Any other expenses, mortgage principal and interest, and taxes to be paid are excluded from the calculation of NOI.
The current market value of the asset: This is the value or purchase price of the real estate property on the date of cap rate calculation.
Using this information, let’s look at an example of cap rate calculation.
The market value of the property based on similar properties is $1,500,000
Annual income on the property is $270,000
The annual operating expenses are $150,000
Considering the above formulae, we can calculate cap rate as follows:
Calculation of NOI: Annual income – Operating expenses = $270,000 – $150,000 = $120,000
Calculation of cap rate: = 0.08 = 8%
Note: The higher the cap rate, the lower the sale price or current price of the property; the lower the cap rate, the higher the sale price of the property. You can check this by changing the market value of the property in the above example.
How is cap rate used in multifamily real estate investing?
When it comes to cap rates, it’s important to know that multifamily properties give, on average, one of the lowest cap rates of all real estate investments – around 4%-10%. The reason for this is the lower financial risk involved in multifamily real estate investments.
Multifamily properties receive a steady income from multiple residents. Given the diverse nature of these residents – many of whom pay rent on time – there is lower risk of the landlord failing to receive the monthly rental income. Because of this, even lenders find mortgage applications for multifamily properties more favorable and are willing to give loans at better rates.
Additionally, it’s been found that multifamily properties in Tier 1 locations, that is, metro cities that have a very large population, offer lower cap rates too. This is because of the high demand for multifamily properties in crowded cities and the resultant low vacancy rates. Similarly, the age of the property affects the cap rate as well. The newer the construction, the lesser the risk because of the limited maintenance requirements.
This reduced cap rate in multifamily properties might indicate smaller yields and a longer payback period, but for landlords, it is also a sign that their investment is less risky.
– The Multifamily Review Team
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Hi, my name is Michael Avent. I founded The Multifamily Review in 2020. I’m a Commercial Agent at Northcap Multifamily located in Las Vegas, Nevada. My vision for The Multifamily Review is to be the most trusted resource for all Multifamily Investors and Industry Professionals. We strive to offer the best and most up to date content to our readers and are always open for suggestions. Make sure you sign up to join our newsletter to stay up to date on our latest blog, ebook, and more exclusive content that’s coming your way! The Multifamily Review team and I look forward to building a deeper relationship with you!
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DISCLAIMER: The opinions expressed in the Blog are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security or investment product. It is only intended to provide education about the multifamily industry.