Using The Cap Rate to Determine The Strength Of A Market

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What is a cap rate and how is it calculated?

The cap rate is short for capitalization rate. The cap rate is the total return you would make off the property if you were to pay for the entire property in full with no debt. 

For example, if you purchase a $1,000,000 property with a cap rate of 5% with 100% cash with no debt then that property would net you $50,000 annually ($1,000,000 x 0.05 = $50,000/year.) 

Here is the formula for calculating the sales price of an asset using the cap rate: 

*NOI: net operating income

This formula is one of the many advantages of investing in multifamily real estate. The value of the property is not based on a set of comps in the area. The value is set based on the net operating income of the property and the going market cap rate. 

Understanding how the cap rate in a particular market is set is important when determining which markets you want to invest. 

High Cap Rate Markets

A market with a higher cap rate will be in a slow-to-no growth, less stable market (see figure 1.) Since the market is not stable with very little, if any, growth, there is much lower competition for the property. 

Figure 1

The buyer pool is much smaller. The seller must increase the cap rate to attract the right set of potential buyers. 

Acquisitions in these markets are higher risk due to the economic instability but typically allow for higher returns (20%+ average annual return) if all goes as planned.

Low Cap Rate Markets

A market with a lower cap rate will be in a high growth, stable market (see figure 1.) These markets are surrounded by blue-chip corporations (see figure 2) providing a greater amount of stability to the market with jobs and income. The buyer pool in these markets is the highest. Due to the buyer competition in these markets, the cap rate is driven down since most investors, especially institutional investors, prefer investing in stable markets. 

Figure 2
Blue Chip Corporations

Acquisitions in these markets are lower risk due to the economic stability and diversity but typically have lower overall returns (14-18% average annual return.) 

As with any type of investment, the higher the risk, the higher the return and the lower the risk, the lower the return. 

Our group stays away from the higher risk investments in multifamily since the returns with the lower risk investments are still great. The lower cap rate markets provide solid risk-adjusted returns. 

The Power of the Cap Rate

Another reason why we go after low cap rate markets is the potential for a higher overall return when we sell the asset.

Many “gurus” will teach the newer investor to go after the high cap rate markets with cap rates in the 8%+ range. In the current market this means you would be going after lower end assets in less stable, tertiary markets. I do not agree with this idea. Let us take a closer look as to why.

If I were to take a similar property in a 5% cap rate market and an 8% cap rate market and compare the potential returns you will understand why we prefer lower cap rate markets. 

If we spend the same amount of time, energy, and effort to increase the operations of the property to increase the NOI by $100,000 in both of these markets, you will see that the higher overall return is in the lower cap rate market. 

In figure 3, the $100,000 increase in the NOI in a 5% cap rate market would allow for an increase of value by $2,000,000

Figure 3

($100,000 / 0.05 = $2,000,000.) If you take that same $100,000 increase in NOI in an 8% cap rate market the value of the asset has only increased by $1,250,000.

Do not get me wrong here, the $1,250,000 value increase is not too shabby but if I can do the same thing in a lower cap rate market and achieve a $2,000,000 value increase, then why not? Right?

In figure 3, you can also see what that would do if you were to increase the NOI by $100,000 in a 9% or 10% cap rate environment. 

Another final benefit of investing in a lower cap rate market where you are projecting a softening of the market (the cap rate upon exit will be higher than when you purchased) is that it allows for an additional room for error in the execution of the business plan. No business plan has ever gone exactly as planned as unexpected things occur throughout the holding period of an asset and this is why it is important to include these extra cushions for these types of situations.