by Cypress Ventures Group
Our last article in our Education Series “Beginners Guide to Multifamily Investing” we explained NOI/ Net Operating Income and Cap Rate – Capitalization Rate. If you want a recap on how to calculate NOI and Cap Rate, click this link or navigate to our website and click the drop down under Passive Investing.
Many of you asked, “What’s a good cap rate?”
Really – what you should ask yourself is, what is a good return for a specific investment for me?
You can compare the return on investment based on the risk you are willing to take. For example, if you put your money in a government insured savings bond you would expect to have no risk of losing your investment. Low risk = low reward. Compare this to investing the same money in penny stocks that could return higher reward but you could lose it all. High risk = higher reward.
As described in the previous articles (Part 1 / Part 2) in this series, cap rates are only one metric to value commercial real estate and are best used to compare the average unleveraged (i.e., no debt) return of similar types of stabilized assets in a market or submarket. The cap rate does not take into consideration mortgages, because mortgage payments are not calculated in the NOI.
The following provides an overview of what might impact an investor’s determination of what a “good” cap rate should be in any given market and asset.
What Relates to Cap Rate
What’s the Risk Profile?
Returns on all investments, real estate and otherwise, are directly correlated to risk. A treasury bond, which is guaranteed by the full faith and credit of the US Government and has one of the lowest risks of any investment but has a relatively low return. Alternatively, junk bonds, which have higher risk ratings and target much higher returns, have a greater chance of default – they are “junky”, after all.
In real estate, a low (less than 5%) cap rate often reflects a lower risk profile, whereas a higher cap rate (greater than 7%) is often considered a riskier investment. Whether an investor deems a cap rate “good” is a direct reflection of whether or not they think the investment’s return matches the perceived risk.
For example, an investor may choose to purchase a Class A, 98% occupied multifamily asset in Columbus, Ohio offered for sale at a 4 cap, which the investor deems is a “good” cap rate, or a Class C apartment in Toledo, Ohio which is being advertised with a 100% occupancy and at a “good” 10% cap rate. Neither investor is wrong, they are reflecting a difference in risk profile and desire for lower risk and lower return or higher risk and higher return. Therefore, the question to ask yourself as a real estate investor is, “Does the cap rate reflect the risk I am willing to take, all things being considered.
How does Time Relate to Cap Rates?
Cap rates on investments also change over time depending upon the macro and micro-economic conditions of the national and local market and the timing of the valuation in the real estate market cycle. When the economy is going well, job growth and consumer confidence usually lead to increased consumer spending. Strong macroeconomics impact everything in commercial real estate from the amount of capital available in the market to buy and finance properties to the actual assets themselves – office space (to locate employees), industrial space (to hold the goods people want to buy), retail space (to buy the goods in the market) and multifamily space (for the employees to live). These are all usually positively impacted by a strong economy. Alternatively, if the economy isn’t doing well, commercial real estate tends to suffer downturns.
Interest Rates?
Interest rates also are a leading economic indicator, and when interest rates rise it is an attempt to control inflation in a growing economy. This also means that the cash flow from commercial properties can support less mortgage debt, and as a result buyers of commercial real estate tend to make lower offers.
A market’s cap rate will change over time depending on how the economy is doing, particularly the economy at the local level.
What’s an Asset Class and How does that Affect the Cap Rate?
For each property type there are generally three “classes” that denote the level of finishes, the strength of tenants and number of amenities, which directly impacts the rents the property can command.
- “Class A” property is the highest asset class, which means it commands the highest rents and the best “quality” tenants, from a creditworthiness and balance sheet standpoint.
- “Class B” property is in the middle of the pack and receives average rents and average quality tenants. Generally, B class properties perform best in both up and down markets. During a down market, when household income may be reduced, A class tenants migrate to safe B class neighborhoods. During a market where households are making more money, the C class tenants will float to the nicer A class property.
- “Class C” property is the lowest quality property and therefore receives the lowest rents and tenants with low creditworthiness.
To tie this back to cap rate, Class A properties have the lowest cap rates and highest values, C properties have the highest cap rates and lowest values.
Once again, the cap rates reflect the risk – real and perceived – that an asset holds. It’s important when considering whether a cap rate is “good,” to know and understand what class, or quality level, the asset is in order to compare to other similar asset types. Example: compare 50 unit apartment complexes in the same city.
What about Deferred Maintenance?
The overall quality of an asset is also impacted by the condition of the property and any maintenance that has been neglected.
High deferred maintenance for an asset may require significant capital for it to receive market rents for its asset class.
Let’s compare two class B properties, both built in the 1980s.
- Property one, a multifamily building has not been updated, needs $500k in updates and is receiving below market rents due to its outdated condition.
- Property two, another multifamily building has received full renovations in the last 12 months and is receiving full market rents.
- The first asset appears to have a weak operating history and has a big capital outlay ahead that is both expensive and may impact tenants and increase vacancy.
- The second property’s financials are strong due lower operating expenses, lower repair costs and it is receiving higher rental rates because it is in a more desirable condition.
Due to the first properties deferred maintenance it should possibly sell at a higher cap rate and lower overall price. The second property that needs no renovations and is already at market rents will have a lower cap and hence a higher price.
What’s the Location?
One of the most significant factors that impact a property’s cap rate is the location. The old saying in real estate is, the only thing that matters is “location, location, location.” This sentiment reflects the importance that location has on the value of an asset. A market like New York City has more jobs, commerce, transportation, and overall economic strength and desirability than a market like Youngstown, Ohio. A market with more demand results in greater property values. I.E. – Cap rates in New York City are much lower and property values are much higher than in Youngstown, Ohio.
As illustrated above, there are many factors that can impact the cap
rate for any asset at any given point in time. Determining whether a cap rate is “good” requires:
- Review the asset in comparison to sales of other like assets in the market at the time of purchase
- Review the current interest rates.
- An honest assessment of the investor’s overall risk profile and tolerance.
Fortunately, there are plenty of sources available to determine whether the cap rate for a specific asset matches the risk-return of similar assets. After conducting the proper diligence and accounting for variations in the property relative to similar properties, it comes down to an individual’s personal preferences, goals and risk tolerance to determine exactly what a “good” cap rate means.
If you want to see more about cap rates, here are a few real estate sources to research for comparable cap rates. These include well-known brokerage firms CBRE, Marcus & Millichap and Colliers which contain asset specific quarterly reports by region and/or city. For other research, please see JLL and Cap Rate Index. Or do a google search and input “multifamily cap rate by city.”
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