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What is a cap rate, and how should I use it in my underwriting?

March 17, 2023

As an investor in multifamily real estate, it’s essential to understand cap rates and how they affect your investment strategy. A cap rate, short for capitalization rate, is a fundamental concept in real estate underwriting that helps you determine the potential return on your investment. In this blog post, we’ll explore what a cap rate is and how you can use it in your multifamily real estate underwriting.

What is a Cap Rate?

A cap rate is a ratio that compares the net operating income (NOI) of a property to its current market value. It represents the percentage of return an investor can expect to earn on their investment annually, assuming they purchased the property in cash. The formula for cap rate is:

Cap Rate = NOI / Property Value

Net operating income is the income generated by a property after deducting all operating expenses such as property taxes, insurance, maintenance, and management fees. The property value is the current market value of the property or the purchase price.

For example, let’s say you’re considering buying a multifamily property with a net operating income of $100,000 and a market value of $1 million. Using the cap rate formula, the cap rate would be:

Cap Rate = $100,000 / $1,000,000 = 10%

This means that if you purchase the property in cash, you can expect to earn a 10% annual return on your investment.

Using Cap Rates in Real Estate Underwriting

Cap rates are a useful tool for real estate investors to evaluate the potential return on investment for a property. By comparing the cap rates of different properties in the same market, investors can determine which properties are undervalued or overvalued.

For example, if you’re considering two similar multifamily properties in the same neighborhood, one with a cap rate of 8% and the other with a cap rate of 10%, the property with the higher cap rate may offer a better return on investment. However, it’s essential to consider other factors such as location, condition, and market trends before making an investment decision.

Cap rates can also help investors determine the appropriate purchase price for a property. By using the cap rate formula, you can calculate the property value based on the expected net operating income and desired cap rate. For example, if you want to earn a 12% return on a property with an expected net operating income of $150,000, you can calculate the maximum purchase price using the formula:

Property Value = NOI / Cap Rate

Property Value = $150,000 / 12% = $1,250,000

In this case, you shouldn’t pay more than $1,250,000 for the property if you want to earn a 12% return on your investment.

Limitations of Cap Rates

While cap rates are a valuable tool for real estate investors, they have some limitations. Cap rates don’t take into account the financing or debt service of a property. A property with a high cap rate may be attractive, but if it requires a significant amount of financing, the returns may be lower than expected.

Additionally, cap rates are only one factor to consider when evaluating a property. It’s essential to consider other factors such as market trends, location, condition, and potential for appreciation. Cap rates should be used in conjunction with other metrics to make informed investment decisions.

Conclusion

In summary, cap rates are an essential concept in real estate underwriting that helps investors evaluate the potential return on investment for a property. By comparing the cap rates of different properties in the same market, investors can determine which properties are undervalued or overvalued. However, cap rates should be used in conjunction with other metrics to make informed investment decisions.

This blog post should not be treated as investment or legal advice.