When investing in multi-family (5+ Units) real estate, the cap rate is often used to determine the price of a given property using its income.
More specifically, the net operating income dictates the price an investor is willing to pay for the given apartment.
Net Operating Income is calculated using an equation: Gross Rent – Total Expenses = NOI. Using the NOI, you can divide the number by a cap rate percentage. Since a percentage figure is often expressed using 0.10 for 10%, it is critical that you divide the NOI by using 0.1 for 10% cap rate or 0.05 for 5% cap rate. What ever your cap rate is, express it using decimal format. For example, if you purchase a $1,000,000 apartment complex on a 10% cap rate. You would expect to earn $100,000 as your Net Operating Income. If you understand how the cap rate works, you would also understand that changing the expenses or the income would have an impact on the cap rate. For example, reducing your expenses while keeping the income the same, you would raise the value of your property (cap rate is consistent) since you can generate MORE Net Operating Income. On the same note, if you can raise your rents while keeping the expenses the same, you can also raise the value of your property. In multi-family (5+ Units), anything you can do to raise your rent, decrease your expense or both will have an upward impact on the value of the property.
But, cap rate is more than just a number. It may also tell a story of how a given market is performing and the quality that it demands. It can also give you an idea as to the classification that the property is in. You may have heard investors use “A, B, C, D, E” to grade a property quality. While this is heavily dependent on your market and other economic factor, generally; you would pay MORE for a better quality apartment building. Thus, you would buy such property at a lower cap rate. Here in our area of Chicago, one could expect to pay anywhere between 3-5% cap rate for an A grade apartment building. However, this can change with the changing economy or an outside force making an impact on the local market.
Another factor that can be driving the cap rate is the local market and its demand. A neighborhood I can think of is Naperville, IL. Naperville is known to have a GREAT school district as well as the overall neighborhood quality is high when comparing to its surrounding villages and cities. Thus, the real estate prices are tend to be higher. An investor looking to buy in Naperville, IL could expect to pay 3-6% cap rate easily knowing that most apartment buildings are within the B+ to A+ classification. Vice Versa, there are certain neighborhoods in the Chicago-land area that are classified as C or D class and properties are tend to be lot cheaper and you would pay 8-15% cap rate.
Both the A+ class and the C- classification bring different sets of challenges. Just because you pay more or less for a property doesn’t mean you get more or less of problems. In real estate, you will almost ALWAYS face challenges in regards to tenants, building maintenance and the local municipal demands. The difference is, you get different types of problems. In my personal opinion, A+ properties tend to be less of maintenance but you do pay a premium upfront. C- properties tend to be more of maintenance but you pay less upfront. Knowing, what I like to call your Investor ID, can help you determine which classification of properties you should invest in. I personally know investors who are GREAT at managing C- properties but are terrible with A+ properties. Vice versa, I know investors who would never touch anything below B class apartment buildings. No single classification is better or worse. It depends on your lifestyle, goals and your ability to deal with certain types of challenges.
Now, I know I used a market specific example here but this concept can be applied to just about any market. In the coastal cities, the scale is shifted. Properties are much more expensive so expect to pay 1-3% cap rate for an A class property in Los Angeles. In fact, most coastal cities have much lower cap rates than most cities in the Midwest. Some of the top commercial real estate brokers may give you an idea of what the average cap rate is for a given market. While there’s not a SET number of cap rate designated by an institution, the cap rate is determined by the market forces. What is the average cap rate that the investors are willing to pay? And all of that is determined by the transactions that are occurring in your market. The best way to determine an average cap rate in your area is to pay attention to what is being sold and not sold. Run the numbers on those properties that are being sold and determine what the average cap rates are.