What Is a Cap Rate?

A cap rate, or capitalization rate, is a way of measuring the return on investment (ROI) of a real estate investment. It is the ratio of the net operating income (NOI) of a property to the price of the property. The cap rate is calculated by dividing the NOI by the price of the property and multiplying by 100, resulting in a percentage rate. For example, if the NOI of a property is $100,000 and the price of the property is $1 million, the resulting cap rate is 10%.

Why Are Cap Rates Important?

Cap rates are important because they provide investors with an easy way to compare the returns of different real estate investments. If a property has a higher cap rate, it means that the investor is earning a higher return on their investment.

In the multifamily housing market, cap rates are an important way to compare properties and make decisions about which properties to invest in. That said, cap rates are only one tool — it is crucial for investors to consider other metrics and aspects of any potential investment.

What Is a Good Cap Rate for an Apartment Building?

While there’s no easy or single answer to this question, there are some considerations to be aware of. Every investor has a different risk appetite for their investments, and while multifamily assets with higher cap rates have, on the surface, a potential greater return, they also generally carry more risk.

Broadly speaking, when investing in an apartment building, investors should aim for a cap rate that is higher than the average for their market. However, if it’s too high, that may be a sign of other issues that could impact the investment later on, such as rents out of alignment with the market or deferred maintenance issues.

Are Cap Rates Different for Different Types of Multifamily Investments?

Yes — the cap rates for different types of multifamily properties can vary significantly. For example, a Class A property typically has a lower cap rate than a Class B property. This is because these properties require a greater capital investment. While rents are also (usually) higher, overall net operating income tends to make up a relatively smaller portion of the investment cost — meaning a lower capitalization rate.

That said, multifamily cap rates tend to be the lowest across any commercial real estate sector, though rates in industrial real estate investment tend to be similarly low in many markets.

Cap Rates for Class A Properties

The table below utilizes data provided by CBRE in its latest cap rate survey, which is published twice annually. The data is valid as of May 2022 and looks at a spectrum of Class A properties across major U.S. markets.

As you can see, there is some variation in cap rates depending on whether or not a property is a stabilized asset or is a value-add play. Value-add investments tend to be riskier, and this is reflected in the capitalization rate. Similarly, suburban properties often have higher associated cap rates than infill communities, though this spread has been less pronounced in recent years.

There is also a significant difference depending on the market. For example, cap rates range from 4.75% to 7.5% for multifamily assets in Philadelphia, while Austin’s rates fall between 3.25% and 3.75%.

What Does a High Cap Rate Mean?

A high cap rate may indicate a good investment opportunity. A high cap rate means the property is generating a higher return on the investor’s investment. While this can be attractive, it is important to consider the potential risks. 

So what’s the potential risk? A high cap rate could indicate that the property is in an area with low rental prices or that the property itself has deferred maintenance issues that could affect its long-term value. Thus, just because you find an investment property with a potentially high cap rate, don’t immediately assume that it’s a great deal. Other factors must always be considered.

What Does a Low Cap Rate Mean?

A low cap rate for a multifamily investment is a sign of a strong market and can be a great opportunity for potential investors. A low cap rate means that the net operating income is higher relative to the purchase price, which means that the investment is more profitable. Low cap rates are often associated with strong markets as they indicate that the demand for multifamily investments is high and the market is healthy. 

Low cap rates can be beneficial for multifamily investors as they can help to reduce the amount of risk associated with an investment. The lower the cap rate, the lower the risk, as it means that the property is generating more income and is likely to remain profitable for a longer period of time. Low cap rates also make it easier for investors to secure financing for their multifamily investments, as lenders are more likely to view the investment as a lower risk. 

However, low cap rates can also be a sign of oversupply in the market, which can be a challenge for potential investors. If there is an oversupply of properties in the market, it can lead to lower rents and higher vacancy rates, which can make it more difficult to generate a profit from an investment. This is why it is important for investors to do their research and assess the market before investing in a multifamily property with a low cap rate.

How Do Interest Rates Impact Cap Rates?

Not everyone agrees that there’s a direct causal link, but multifamily capitalization rates tend to increase as the cost of capital increases. It makes sense when you think about it: If borrowing becomes more expensive, this will necessarily impact property values. If a property’s value decreases with all other factors held the same — rents, operational costs, and so on — the cap rate will increase for that investment.

How Can I Calculate My Cap Rate?

Calculating a cap rate for an investment couldn't be simpler: Just use our cap rate calculator below. All you need to provide is your property or investment's market value or purchase price along with its net operating income.

Conclusion

Cap rates are an important way to compare the returns of different real estate investments. When investing in multifamily properties, investors should consider the cap rate of the property and compare it to other properties in the same class. Generally, properties with higher cap rates are considered to be better investments.