Utilizing CAP Rates to Determine Your Return on Investment

 

A capitalization rate, or CAP rate, is what investors expect to earn as a percentage of their investment on an annual basis.  Commercial multifamily properties and commercial real estate valuation is very complex and has many variables that affect price. Read on to learn more about calculating your CAP rate so you can easily compare the investment potential of multiple properties.

CAP Rate Calculators

Many investors, and those looking to purchase multifamily properties, compare property values and the price they are willing to invest by calculating the capitalization rate.  An investor looking to earn eight percent annually on a transaction will look for a property with a capitalization rate of eight.

The general rule: the lower the capitalization rate is, the higher the property value will be.  
The opposite is also true: the higher the capitalization rate is, the lower the property value will be.  

CAP Rate Formulas

Value = Net Operating Income (NOI) divided by Capitalization Rate (CAP)
Capitalization Rate (CAP) = Net Operating Income (NOI) divided by Value

Another way to look at the CAP rate is to determine the Net Operating Income (NOI). You simply calculate income minus expenses, divided by the purchase price or the appraised value of the property.  Investors need to apply a precise CAP rate in order to accurately predict the rate of return that the project will receive for both their investors as well as themselves. Included below is an example for an investor looking to purchase a multifamily property for $8 million dollars with a Net Operating Income (NOI) of $800,000.

To find the CAP rate and the annual rate of return use the following formula:
NOI of $800,000 divided by the property price of $8,000,000 = .10
Then multiply by 100 = 10% CAP rate
Since the CAP rate is 10%, investors can expect a 10% annual return on investment.  

Current Multifamily CAP Rates

There are different classifications of multifamily properties that range from Class A to Class C, each with unique attributes.

  • Class A Properties: Those with the highest quality, in the best location, or the in newest condition (recently renovated).
  • Class B Properties: Those that are not the newest, don't have the highest quality, or are not in as desirable of locations compared to Class A properties.
  • Class C Properties: Those that are older, in less desirable locations, and can potentially require extensive renovation.

CAP Rates for multifamily apartment properties are relatively flat for 2019 in this market. They are currently averaging 4.60 for newer luxury metro properties, 4.87 for Class A properties, 5.24 for Class B properties, 6.02 for Class C properties, and 6.40 for Value Added Acquisitions.
Source: Apartment Loan Store

The multifamily properties that are located in areas that are in high demand have lower CAP rates.  Cities including New York City, San Francisco, Chicago, and Los Angeles have low CAP rates due to their market strength. Areas that are in lower demand and are considered weaker in market strength have higher CAP rates and provide higher returns that come with increased risk.  

If you are looking to purchase a property or are looking for information on an estimated CAP rate for your multifamily property, LSG Lending is available to discuss your project and possible loan programs for your purchase or refinance.

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