Jan 29, 2021 4:00:00 AM | 8 Min Read

What Smart Investors Should Know About Real Estate Cap Rates

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KRI Partners
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What Smart Investors Should Know About Real Estate Cap Rates

Do Cap Rates really matter in multi-family real estate investing? Why do I need to know about Cap Rates?

Yes!!! You absolutely must understand real estate Cap Rates because if you don’t, they can negatively affect your investment and even cause you to lose a lot of money. I’m not sure about you, but if something could potentially cause me to lose money, then you can rest assured that I will make sure I really understand it.

Let’s start by explaining what a real estate Cap Rate is and how it affects value. Once we understand that, then we can analyze the effect it can have on multi-family real estate investing.

How to Calculate Cap Rate on Rental Property

The cap rate is a number that represents the weighted average cost of capital required to purchase an income-producing asset. Real estate investors use it to determine the value of an income-producing property. The best way to explain this is to illustrate how to calculate Cap Rate on rental property (including multifamily) and then I will show you its effect on value.

First, when you buy a property you have to pay for it. Usually, some of the money comes from a lender (debt) and the rest comes from investors (equity). A typical ratio is 70% debt and 30% equity. 

OK, let’s say the interest rate for a mortgage loan to buy an apartment community is 4% annually. Let’s say the investors who are willing to put their money into the deal expect a cash on cash return of 8% annually from the cash flow of the property. They determined that 8% is a fair return for the type of property and the neighborhood. It is basically their assessment of the risk of owning the property.

Let’s use this information to calculate a cap rate.

Purchase price $10,000,000 (100%)

Amount of debt $ 7,000,000  (70%)

Amount of equity $ 3,000,000  (30%)

 

Here’s the calculation of the weighted average cost of capital.

Debt 70% x 4% 2.8%

Equity 30% x 8% 2.4%

Total 5.2%

 

This means that if the lender wants a 4% return, and the investors want an 8% return on their cash, then the property must produce a return of 5.2% in order to satisfy everyone in the deal. 

In our example, our $10 million property must produce at least $520,000 of cash flow each year to make everyone happy.  

Now let’s use this cap rate to try to figure out how much a property is worth. Let’s say we have an apartment community located near the first one above and when you consider the revenues and expenses of the property, you determine that it can generate a cash flow of approximately $450,000 annually. How much is it worth? Don’t forget, the cap rate is still 5.2% (same property type, neighborhood, lender, etc.).

Calculation:

Annual income $450,000

Divided by Cap Rate       5.2%

Fair market value (FMV) $8,653,846

In this example, we simply rearranged the formula we used in the first example to calculate fair market value. Notice we have a similar property, same lender, same investor. The difference is in the amount of cash the property produces. In order to be worth $10 million like our first example, the property would have to generate $520,000 per year. In this example, the property produces less cash, so it’s worth less ($8,653,846).

You can prove this out by multiplying the FMV of the property by the cap rate and you will get the annual required income to satisfy everyone in the deal ($8,653,846 x 5.2% = $450,000). 

As you can see, when multi-family real estate investing, using cap rates to help value a property isn’t overly complicated. It is a fairly simple math equation and, once you understand how to change it to calculate what you are looking for, it will become second nature to you.

The key to using cap rates in real life lies in knowing which cap rate to use when you are analyzing a deal. The lender interest rate part of the equation is the easy part. You can get the interest rates from any mortgage broker.

How Real Estate Cap Rates Affect Multi-Family Real Estate Investing

The challenge is determining the equity investors’ required rate of return. That portion of the equation is determined by numerous investor, property, and market-related factors.

  • Neighborhood
  • Type of property
  • Type of investor
  • Demand for apartment deals
  • Investors’ outlook on the economy
  • Amount of projected value creation possible

As you can see, there are a wide range of factors that drive this portion of the cap rate equation. Sometimes these factors are easy to predict and sometimes they aren’t. For example, if there is a huge investor demand for apartment deals then, in order to get the deal, there may be investors willing to reduce their return requirements and, as a result, pay a higher price. 

Another example is when different investors have different objectives. An investor may be simply looking for a safe place to invest his or her cash without really requiring much of a return at all. This happens a lot when an investor’s home country investment alternatives are not very attractive (maybe they can only earn 1% on real estate at home). Or it could even be that an investor’s home country currency’s value is fluctuating, and the investor is looking for an investment in a stable currency in an asset class they deem as safe.  This happens all the time.

As you can see, this is where it gets complicated. To deal with these issues, you simply have to have experience, be thorough in your financial analysis of the property, and understand YOUR return requirements. That may even require you to walk away from deals that don’t make sense. 

Not Understanding Real Estate Cap Rates Could Lose You Money

Well, what happens if you buy a property and, when you’re ready to sell, you realize interest rates have changed? Or investors’ return requirements have changed? If that happens, by definition, the cap rate has to change to accommodate the new, revised return requirements of the lender and/or the investor. 

In our previous example, what if our $10 million property that produced $520,000 annually still produces $520,000 of cash each year but now the lender’s interest rates have increased to 5%? The new weighted average cost of capital (remember, that just means cap rate) becomes 5.9%. That means our $10 million property is now worth $8,813,559. That means that just because interest rates went up 1%, we just lost $1,186,441 in value.

Whew, that’s a lot of money to lose.  We need to plan for that, wouldn’t you agree?

To avoid this problem, real estate investors use a concept called a “Reversionary Cap Rate,” which is also known as a “Terminal Cap Rate”. It is the cap rate they apply to their pro forma projections so they can determine what they think the value of the property will be when they are ready to sell it. They use all the information at their disposal to estimate what they think the environment will be when they are ready to sell. Most of the time, most investors will use a higher terminal cap rate than the cap rate they used when they bought the property. This provides some level of safety in their analysis.

This terminal cap rate risk is a real risk investors face. It is especially critical now. As of December 2020, cap rates are extremely low. It is because interest rates are low and investors like investing in real estate (high demand). This has driven cap rates to historic lows. If/when interest rates go up, or investors sour on real estate, the cap rates are sure to go up in the future. 

It is for this reason that the most successful projects will be value add projects where an operator can raise income and lower expenses to more than offset the effect of higher terminal cap rates.

As you can see, real estate Cap Rates are complicated. If you are thinking about multi-family real estate investing, especially as a passive investor, you must make sure the company you are investing with has enough experience to recognize and deal with these issues.   That’s where KRI Partners comes in!

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