Capitalization Rates, or Cap Rates, are what commercial real estate investors, those like us, investing in multi family real estate, use as a fundamental concept to determine the value of a property. The cap rate is a good point of origin in evaluating commercial real estate, but it is just one of many factors.
When we are looking at a property, the Cap Rate represents the rate of return on a real estate investment property based on the income the property is expected to generate. The Cap Rate is a metric used to estimate the investor’s potential return on his or her investment. The Cap Rate can be a great tool to assess other comparable real estate investment properties.
To estimate it simply, you divide the net operating income (NOI) by the total current value of the property or acquisition cost and this gives you the Cap Rate. When you are looking to invest in a property, you are typically looking for higher Cap Rate, because this means that you will see a better investment at a lower risk. The inverse is true, a lower Cap Rate can mean higher risk. But remember, there are many other factors that go in to a property’s Cap Rate, so don’t just stop at finding the NOI and current value, you must do your research and analysis to understand the property (age, condition, location, turnover/vacancy, improvements, expenses, long term leases/tenant strength, etc.) However, sometimes the property values are bid up by the market even when the NOI remains the same, thus lowering the Cap Rates resulting in Cap Rate compression.
More often than not, Cap Rate compression shows us that the market is rising. And this can cause investors to carelessly jump on the train of low risk, high reward properties. However, if the property value has been inflated, this can be a huge risk for newer investors who are just breaking into the market, and less of a risk for those who have been investing longer and have more ability to float in the market. Cap Rate compression is result of cash in the market. With REITs, hedge funds, and other institutions such as life insurance companies paying record prices for properties, competition between brokers and sellers peaks as a result. As interest rates rise, additional pressure is placed on real estate investors who typically leverage their investments with debt.
There are three things to consider when evaluating Cap Rates. First is the demand for certain kinds of properties in specific locations. Second is supply of property available to buy or lease and how much new stock is coming on to the market. And lastly you have to factor in the dynamics of the investment and debt markets, because property’s return on investment must be seen relative to other investment avenues, such as the stock market. The cap rate application is much more complicated as it is just one of many factors in assessing the return on commercial real-estate property.
If you are new to multifamily real estate investing and are looking for somewhere to start, head to our contact page and fill out the form. Here at Magnolia Design Properties, we are ready to invest with you and for you. And we believe that through education and hard work, we can generate great returns for our accredited investors. If you have any questions at all about the investment process, don’t hesitate to reach out, we want to help you find real estate options that work for you!
