What is a Good Cap Rate for Multifamily?
Multifamily property investing is one of four major commercial real estate investment asset classes that is increasingly claiming its share of real estate portfolios, however, like all investments multifamily has its own set of risks. Understanding the cap rate of a property can help you manage that risk and steer clear of high-risk low reward investments, but what is a good cap rate for multifamily?
For the purpose of this article, we would like to focus specifically on multifamily, which we believe is a relatively safe investment option with low cap rates.
What Is a Cap Rate?
Cap rate means “capitalization rate.” It’s a key metric real estate investors use to analyze potential investments and objectively compare one with another. Knowing a property’s cap rate helps you assess the risk as well as return on investment (ROI). As a real estate investor, you will use this metric to both identify a good investment opportunity and determine property management effectiveness for your existing portfolio.
How to Calculate a Good Cap Rate for Multifamily Properties
Fortunately, a multifamily cap rate is easy to calculate, so much so that eventually, doing cap rate calculation in your head will become second nature.
Start by finding your net operating income (NOI).
Gross income – Operating Expenses = NOI.
NOI / Purchase Price = Cap Rate
Let’s look at an example of how you might use the cap rate formula.
Multifamily Investment Property in Your Portfolio*
Last year, you purchased a fully occupied quadraplex called Marvin Gardens for $1,000,000. Your gross rental income was $70,000. You lost one tenant in August unexpectedly and didn’t get a new one until October. Your expenses were $15,000.
- $70,000 – $15,000 = $55,000
- $55,000 / $1,000,000 = 5.5%
Your cap rate for last year was 5.5%. Is this a good cap rate? It can be. We will soon see what a good cap rate for multifamily looks like.
Why Is Cap Rate So Important for Real Estate Investors?
A commercial property with a lower cap rate means lower risk while a higher cap rate typically comes with higher risk (such as age or inferior location). However, just like a savings account, the rate of return can be so low that there is no profitability or cash flow. Somewhere in between investors hit that elusive sweet spot — just enough risk to generate an acceptable reward. Cap rates are also a good tool to compare the pricing of your properties to comparable sales.
When everything is said and done, buying high cap rate properties should deliver the highest ROI over time.
What Is a Good Cap Rate for Multifamily Investment?
First of all, multifamily investments have lower cap rates than other properties where a good cap rate is around 8-10%.1 That doesn’t make the lower cap rate of a multifamily a lousy investment, but you cannot necessarily compare the two. This is just one factor to consider.
A good cap rate for multifamily is over 4% and could be as high as 10%.2 That range comes down to the fact that several factors can influence a good cap rate and possibly make a low cap rate look better or a good one look worse than it is. According to CBRE’s 2021 Cap Rate Survey, the average cap rate on multifamily is around 5.4%.3
Through our research, we believe there are two factors that primarily influence what a good cap rate looks like.
Properties are broken into three classifications based upon the property’s age. As a general rule, an older property costs more to maintain with the potential for a significant expense any given year, raising the costs and lowering the cap rate. For example, Class A is less than 10 years old, while Class C would be 30 years or older.
Some cities have higher costs of living and doing business. Higher property taxes, operating costs, vacancy and investor demand can influence a location’s potential cap rate. For example, the cap rate you might expect in Los Angeles may be below 4%, while Memphis should be closer to 10%.
Location is broken into tiers so as not to be confused with asset vintages:
- Tier I properties are located in more desirable cities and tend to have lower cap rates.
- A Tier II is growing fast and has the potential to become Tier I, but for the time being, the cap rate is still good.
- At the other end of the spectrum, a Tier III is in an economically strong but not yet overpriced city. These tend to be smaller up-and-coming places.
We bring your attention to the fact that Tier I has lower cap rates since you might expect the tiers to move in the other direction. Tier I’s are at the top because despite having lower cap rates, they also have higher value properties and low vacancy rates because a great rental is a hot commodity.
EquityMultiple Can Help You Invest
Many want to access investments with diverse risk/return profiles with shorter return timelines, but the entry point seems out of reach both in terms of time and money. EquityMultiple gives you a practical way to invest in multifamily properties from sponsors who know what the cap rate tells them.
Sign up to learn more or start investing today.
1Source: Forbes (as of November 1, 2018).
2Source: 2ndKitchen (as of May 21, 2020).
3Source: CBRE U.S. Cap Rate Survey H2 2021 (as of March 7, 2022).
*For illustrative purposes only. There can be no assurance that any investment will achieve its objectives or avoid substantial losses.
This document is for informational purposes only and is not an offer or solicitation to purchase or sell securities. Investing involves risks, including the potential for principal loss. There is no guarantee that the strategies and services will be successful or outperform other strategies and services. Certain assumptions may have been made in connection with the analysis presented herein, and changes to the assumptions may have a material impact on the analysis or results.
¹Past performance is no guarantee of future results. The investments discussed herein may be unsuitable for investors depending on their specific investment objectives and financial position. Investors should independently evaluate each investment discussed in the context of their own objectives, risk profile and circumstances.
All opinions expressed herein constitute EquityMultiple’s judgement as of the date of this article and are subject to change without notice. Statements made are not facts, including statements regarding trends, market conditions and the experience or expertise of EquityMultiple, are based on current expectations, estimates, opinions and/or beliefs of EquityMultiple. Such statements are not facts and involve known and unknown risks, uncertainties and other factors. Past events and trends do not predict or guarantee or indicate future events or results.
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