Understanding Cap Rates in Real Estate Investment
Introduction
When evaluating multifamily real estate investments, capitalization rates (cap rates) are one of the most fundamental metrics used by investors. This guide will help you understand cap rates, their relationship with treasury yields, and how they impact property valuation.
Important Disclaimer
G2H Companies and its affiliates (like The Multifamily Power Valuator) are experts in multifamily real estate and make no claims to be financial advisors, stock/bond experts, or tax experts. This is NOT personal investment advice. Please use this as a starting point to spearhead conversations with local professionals that can provide context specific to your situation.
What is a Cap Rate?
A capitalization rate is a ubiquitous metric in commercial real estate that indicates the expected level of return on a property investment. It originates from the "Income" approach to valuation used by appraisers, which uses a property's net operating income to derive fair market value.
Example Calculation
For example, if an investor found a property on the market for $100,000 with an advertised cap rate of 10%, that investor could expect the property to generate approximately $10,000 (or $100,000 × 0.10) in Net Operating Income.
Property Value
Decrease From Peak
Formula
Cap rates serve as a baseline metric that investors and brokers use to bridge the communication gap during negotiations. Discussing the full set of underlying metrics and fundamentals for a multifamily property can be exhaustive during initial conversations, so many professionals use cap rates as a "gut-check" to determine if the "bid-ask spread" is reasonable enough to warrant more time investment in the deal.
Treasury Yields and Cap Rates
What is a Treasury?
A "Treasury" is a fixed-rate investment typically considered one of the safest investments in the world because it's backed by the full faith and credit of the United States government.
The Treasury market is divided into three distinct segments based on maturity:
T-Bills
Short-term securities
T-Notes
Medium-term securities
T-Bonds
Long-term securities
The Relationship Between Cap Rates and Treasury Yields
The relationship between cap rates and treasuries typically centers around the 10-Year Treasury yield. This connection exists because many commercial real estate investments are structured with 5, 7, or 10-year debt terms.
Investors compare the return of the Treasury against the anticipated return on a real estate investment and expect to see a positive spread. In other words, they expect the real estate investment to produce a greater return than the Treasury, compensating for the additional risk.
The Treasury yield is typically used when investors calculate their cost of capital, filling the "Risk-free Return" component of their analysis.
How to Determine the Right Cap Rate
There's no single "correct" cap rate to use, as it depends on numerous factors. In any transaction, there are effectively two cap rates at play:
Buyer's Cap Rate
The cap rate a willing and able buyer would pay
Seller's Cap Rate
The cap rate at which a willing and able seller will transfer ownership
To determine an appropriate cap rate, you should:
Consult with local real estate professionals
Analyze recent comparable sales
Evaluate your capital structure
Calculate your cost of capital
Consider other operating variables
The Importance of Solid Underwriting
Execution is key in real estate investment. Putting properties under contract with inadequate underwriting and failing to close can quickly damage your reputation as an investor and make future deals more difficult.
Pro Tip
Thorough analysis and realistic expectations regarding cap rates and returns are essential for successful real estate investment. Use tools like the Multifamily Power Valuator to ensure comprehensive underwriting before making investment decisions.