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Calculating the Capitalization Rate or Cap Rate is relatively simple. There is a formula most people refer to as IRV (Income/Cap Rate/Value). If you have the net operating income (NOI) of a property then you can divide the NOI by the Cap Rate to determine its value. For example, say you have a property that all documents show is reflecting a NOI of $100,000 and you know the cap rate is about 5%, you solve as shown below:
In the slides above, you have put in the work by making renovations to the property, changing management, reassessing taxes, etc. An increase in NOI, will produce more cashflow for your investors during the hold period; however, the value of the property only increases $83,000 because cap rates increased during the hold period. I won’t provide the full underwriting here, but that is not enough to present an attractive yield to investors.
The Impact
So now that you know cap rates are important and drive the cost of the property, you might be asking where do I get this number? In short, cap rates are driven by the particular market you are in. The higher the cap rates the cheaper the property and vice versa. If you are looking at multifamily properties in more affordable Metros, e.g., Memphis, Baltimore, Birmingham, then expect a high cap rate something between 6% to 8% is generally the norm in these markets. If you are looking at multifamily properties in San Diego, expect brokers to laugh when you tell them the Cap Rate you desire – here they hover in the low 4% range or sometimes lower.
As an investor, you prefer to buy at a higher cap rate and sale at a lower cap. Going in the opposite direction should be avoided at all costs, for the reason mentioned above. You’re probably wondering how to make sure that cap rates go down. The first step is market research. Cap rates go down as property in the market becomes more valuable. This is driven by the usual factors: job growth, population growth, new construction, crime, etc.
There are additional external factors that can affect Cap Rates. One very notable and timely factor is interest rates. As a general rule, lower interest rates will most likely lead to lower cap rates because there is more capital to compete for properties on the market. A study conducted by Peter Linneman focused on which factors affect changes in cap rates. His study found the availability of capital and capital flows had major impacts on cap rates. This makes sense because capital flows directly reflect the overall health of the GDP, thus increasing available capital. Furthermore, increased availability of capital will increase competition compressing cap rates and driving up property values.
Conclusion
The big take away here is to make sure you have partners in desirable markets. That means markets with increasing job growth and population growth. This can be difficult as we are coming off the COVID migration and workers are being called back to the office. An additional wrench in the calculus is the influx of new construction in 2024, especially around the sunbelt, decreasing demand and driving up cap rates in certain areas. Always make sure your partners or sponsors on a deal can sell the market, and especially the submarket before digging into the value add strategy.
