The Capitalization Rate or "cap rate" is one of 5 key value indicators to consider when investing in apartment buildings. If you haven't heard the term by now, you will. Agents, buyers, sellers and lenders all talk "cap rates."
Though important, don't let your entire investment strategy hinge on the cap rate. If you do, you might find yourself overpaying for one property while missing out on other great opportunities that could make you tens of thousands, even millions, more. Carefully consider other value indicators such as the Gross Income Multiplier (GIM), Cash-On-Cash Returns (C/C), price per foot ($/ft) and price per unit ($/unit). The cap rate means little if all the other value indicators are out of whack.
The cap rate is calculated by dividing the Net Operating Income (NOI) by the purchase price. For example, if we buy a property with an NOI of $98,486 for $1.1M, we have a cap rate of 8.95%. If we buy a similar property with an NOI of $88,781 and buy it for $1.1M, we have a cap rate of 8.07%. As investors we want high cap rates because, theoretically, we pay less for the same income when compared to a similar property. All things being equal, most of us would opt to invest in the property with an NOI of $98,486 versus the other.
What is the right cap rate?
There is no "right" cap rate. It depends on the market. And even then, it varies. It's impacted by the location, age, unit mix, tenant profile, buyer pool, rental upside and much more. I've bought and sold properties that were a full point higher or lower than other properties in the same area. It just depends on the property and the market.
How do you determine the "market" cap rate? The first step is to understand how to properly calculate NOI. If the NOI is wrong, so is everything else. Next, contact lenders and appraisers who specialize in apartment buildings. If you're buying in the right place at the right time they'll spend a few minutes talking to you about the market. You can also contact real estate agents and ask for sale comparables. Most of them will be happy to help.
Many investors pass on great opportunities because they fail to see value in a property. I recently closed on an apartment building after two other investors backed out, and at the same price. I did everything I could to put myself in position to get the property, yet my counterpart elected to try to sell it to his onsite manager first. After she backed out it went under contract with an agent he knew. I hoped it would come back around, and this one did. The reason buyer number two backed out was because, in his mind, the cap rate was too low. He didn't believe in the numbers. Maybe he was positioning to further negotiate. I don't know and I wasn't going to sit around to find out. I closed on the property, put nothing into it and sold it 6 months later for a $250,000 gain.
The point is this: Understand what the cap rate is today and what it means to your investment. Then, blend that information with all of the other factors that help determine whether or not the property is a good investment. If you do that your chances of making a quality investment will increase dramatically.
Wish you all the success,
Steve Steadele
About Steve:
Steve Steadele, author of the book Multifamily Millionaire, is a successful Real Estate Investor, Broker, Entrepreneur and self-made millionaire. He is a featured speaker at Real Estate Investment Associations across the country where he shares his wealth of knowledge, experience and enthusiasm for the real estate industry. Today Steve specializes in the acquisition and disposition of investment real estate throughout the United States. To learn more about his products and services, visit his Web site at www.SteveSteadele.com.
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