A capitalization rate, or simply cap rate, is used in multifamily financing to determine the annual net gain or loss of profit on an investment that is expected to be generated on an apartment property. A cap rate is calculated by dividing the net operating income of a property by its market value. The metric is expressed as a percentage.

How Do You Calculate a Cap Rate?

The capitalization rate can be found by dividing an asset’s net operating income by its current market value. To better understand how to calculate cap rate, imagine a property with a net operating income of $500,000 at a market value of $5 million. This property would have a capitalization rate of 10%.

Capitalization Rate Formula:

The capitalization rate can be determined by utilizing the following formula:
⁠Capitalization Rate = Net Operating Income ÷ Current Market Value

In the example above, $500,000 (NOI) divided by $5,000,000 = 10%, the cap rate.

Understanding and Utilizing Cap Rates

Cap rates are utilized by appraisers to determine the value of a commercial property. This metric is also the key behind the income capitalization approach to property valuation. Put simply, a cap rate represents the yield of a property over the duration of a year. A cap rate also indicates the length of time it will take an investor to recover a staked amount in a property. In other words, a property with a cap rate of 10% would be expected to take around 10 years for an investor to recover the investment amount. Additionally, you can use the relationship between a property’s NOI and cap rate to determine the property value if you know what cap rates similar properties (those of similar vintage and asset class) are trading for in that submarket.

While capitalization rates can be useful for lightly comparing the relative value of similar properties on the market, they shouldn’t be used as the sole indicator of an investment property’s strength because it does not take some key factors — such as leverage — into account.

Since capitalization rates are based on projected estimates of future income, they are subject to high variation. It is imperative for an investor to understand what constitutes a good cap rate for an investment in any given situation. In regards to apartment loan programs, there are no clear ranges for a good or bad cap rate, and the ranges that investors do find are broadly dependent on the context of the property and the market it resides in.

Understanding the Cap Rate for Rental Properties

The cap rate, or capitalization rate, is a crucial metric for investors to consider when evaluating the potential profitability of a rental property. It is calculated by dividing the property's net operating income (NOI) by its current market value.

The NOI is the total income of the property minus its operating expenses. The higher the NOI, the more profitable the property is likely to be.

A high cap rate indicates a higher potential return on investment for the rental property. For example, if a property has a cap rate of 10%, this means that the potential return on the investment is 10% of the property's market value.

What Is a Good Cap Rate for a Rental Property?

The short answer is that it depends. High-demand markets with high property values will have notably lower cap rate averages than lower-demand parts of the country with stagnating market values.

In 2022, multifamily cap rates hit their lowest point in years, reaching between 3% and 4% for Class A properties in some of the tightest markets. Since then, they've started to climb significantly (especially in certain markets).

There are some regularly released reports that highlight cap rates (particularly CBRE's semiannual cap rate survey) that can provide excellent guidance here.

How Is a Cap Rate Different from a Gross Rent Multiplier?

While cap rates and gross rent multipliers are both commonly used metrics for evaluating investment properties, they differ in several ways. As mentioned earlier, cap rates are based on the property's net operating income and market value, while GRM is based on the property's gross rental income and price.

Cap rates provide a more accurate picture of the investment potential of a property, as they consider the property's operating expenses. In contrast, GRM only considers gross rental income and the property's purchase price, without taking into account the property's operating expenses.

Moreover, cap rates are more widely used in commercial real estate, while GRM is typically used in residential real estate. This is because commercial properties often have more complex operating expenses and income streams, making cap rates a more appropriate metric for analysis.

Another key difference between cap rates and GRM is that cap rates are a better indicator of the risk associated with an investment property. A higher cap rate indicates higher risk, while a lower cap rate indicates lower risk.

In summary, while both cap rates and GRM are useful metrics for evaluating investment properties, they differ in the way they measure the potential return on investment. Cap rates provide a more comprehensive view of the property's income and expenses, making them a better metric for commercial real estate. Cap rates also provide a better indication of risk, making them a valuable tool for evaluating investment potential.

In this article:

Capitalization Rate Calculator
What Is a Cap Rate?
How Do You Calculate a Cap Rate?
Capitalization Rate Formula:
Understanding and Utilizing Cap Rates
Understanding the Cap Rate for Rental Properties
What Is a Good Cap Rate for a Rental Property?
How Is a Cap Rate Different from a Gross Rent Multiplier?
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What Is a Cap Rate?