“What is a good cap rate?” This is one of the most common questions we get from investors that are starting their journey into the commercial multifamily investing space. While it’s a good question for an inquisitive mind, “good” is a relative term and highly dependent on the individual investor. What may be deemed “good” to one, may be “poor” to another.
With that being said, let me breakdown three key factors that will have an impact on whether a capitalization rate (cap rate) is “good” or “bad”:
1. Your Strategy
It all starts with you! The strategy you are pursuing will have a significant impact on how you perceive cap rates.
Generally, the higher the cap rate, the less you are paying for the income it produces. The lower the cap rate, the more you are paying for the income it currently produces.
If you are looking to buy apartment buildings that generate positive cash flow from the date of acquisitions, low cap rates are not going to cut it for you. With this strategy, you will need to buy properties that have higher cap rates (remember, cap rates are a measure of how much a property produces in net operating income (NOI) relative to the value or purchase price. Cap Rate = NOI / Purchase). The higher the cap rate, the more cash flow the property is likely to produce for you. Keep in mind that cap rates do not take financing costs into consideration. So if you are placing higher interest debt to purchase the property, a high cap rate property may not cash flow at all.
If your strategy is to buy under-performing assets and reposition them for profit (value-add or repositioning strategy), you will likely be more comfortable purchasing properties at lower cap rates in comparison to someone that is buying primarily for immediate cash flow.
As you can see, the strategy you choose to execute on is a primary determinant on how you perceive cap rates.
2. The Specific Market Area
Another factor that must be considered when evaluating cap rates is the market(s) you have decided to invest in. In general, apartment buildings located in small markets (lower relative population) tend to be valued at higher cap rates, while commercial properties in larger markets tend to be valued at lower cap rates.
Going back to the main question—what is a good cap rate—it is also highly dependent on the market you are investing in. An investor that invests in small northern communities may be happy with an 8% cap rate on purchases, whereas an urban investor will gladly pay a 2-3% cap rate. Both investors are happy with their respective rates, while both are drastically different.
Below you will find a comparison of the dynamics between low and high cap rate markets.
3. Current Financial Performance of the Building
The third factor that you will need to consider when assessing a cap rate is the financial performance of the building.
As a reminder, cap rate is calculated as follows:
All else being equal (property, strategy and market in this case), a building with a higher cap rate is performing better financially than one with a lower cap rate.
"Good" or "Bad"
The next time you are reviewing cap rates of a particular investment opportunity or you feel the urge to ask “what is a good cap rate”, consider these factors to decide whether it is a “good” one for you.
Watch our discussion on this very topic...
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About the Author:
Mark Baltazar, Co-Founder of Peak Multifamily Investments
With 18 years of experience in business strategy and corporate consulting on the global stage, Mark brings a wealth of business management and operational expertise to real estate investing. Winner of the Real Estate Investment Network’s Top Player Award in 2017, Mark continues to build strong momentum in growing his real estate portfolio.
His strong analytical background enables him to bring a strategic rigour to portfolio expansion and the assessment of investment opportunities.
With five years of real estate investing experience across various strategies, Mark oversees Peak’s capital raising, client acquisition, partner relations, educational content development while ensuring the company delivers on its promise of helping others build generational wealth through apartment building investing.