Understanding Cap Rates: A Real Estate Investor’s Perspective

It’s a way to evaluate a potential investment property and compare its income-generating ability with other properties. However, it does not tell you how much cash you will take home after mortgage payments, capital improvements, and other cash requirements.

Formula

Cap Rate = Annual Net Operating Income (NOI) / Property Market Value

Example: A property generating $200,000 in annual NOI with a $5,000,000 market value would have a cap rate of:

$200,000 / $5,000,000 = 4%

What is NOI?

Net operating income is the income a property generates after operating expenses, before debt payments, income taxes, depreciation, and capital expenditures. It strictly looks at the property’s income-generating ability, independent of how the property is financed.

This generally means rental income and other property income, adjusted for vacancy and collection losses, minus operating expenses such as property taxes, insurance, management, repairs, and owner-paid utilities.

What is a “good” cap rate?

A desirable cap rate will ultimately vary based on the investor and their needs. The market, property type, location, condition, and other factors can all impact expected cap rates. There is no single range that applies to every property or market.

A higher cap rate may offer more operating income relative to the purchase price, but it can also reflect greater risk or weaker growth expectations. A lower cap rate may reflect a stronger location, more stable income, or greater anticipated growth.

Other considerations

• Interest rates: While interest rates are not directly included in the cap rate calculation, they can have an indirect impact. Rising interest rates increase borrowing costs and can put upward pressure on cap rates and downward pressure on property values. However, the relationship is not always immediate or one-for-one.
• Your required return: A “good” cap rate is one that fits your investment objectives given the property’s risk profile and expected income growth. Cap rate alone should not be compared directly with your required total return, since it does not capture appreciation, future income changes, or the effects of financing.
• Stage in the economic cycle: Holding NOI constant, cap rates move inversely to property values. During economic expansions, stronger investor demand and growth expectations can lead to cap rate compression, meaning cap rates go down. During downturns, greater uncertainty and higher required yields can lead to cap rate expansion, meaning cap rates go up. These are tendencies, rather than fixed rules.
• The numbers behind the cap rate: Confirm whether the calculation uses actual historical NOI or projected NOI. A cap rate based on anticipated rent increases or lower expenses may look attractive, but those assumptions still need to be achieved.
• The broader investment picture: Cap rate is just one of many metrics to evaluate when identifying the best opportunity. Other considerations include Internal Rate of Return (IRR), cost of capital, cash-on-cash return, Debt Service Coverage Ratio (DSCR), occupancy rate, operating expense ratio, price per square foot, comparable sales, and Loan-to-Value ratio (LTV). These should be considered together when evaluating a multifamily deal to add to your portfolio.