Ethan On A Tangent

Multifamily Cap Rates: Decode the Math to Maximize Returns

Ethan Tang -

Cap rates (short for capitalization rates) are a cornerstone metric in real estate investing, particularly for multifamily properties. They’re a quick and powerful way to gauge potential returns and compare investment opportunities. But cap rates do more than crunch numbers—they tell a story about the market, risk, and opportunity. Here’s a guide to cap rates with actionable insights for multifamily investors.

At some point, I will likely begin looking for more esoteric metrics to help me spot interesting deals but for now, we stick to the classics.

What Are Cap Rates?

At their simplest, cap rates measure your annual return on investment if you paid for a property in cash. Here’s the formula:

Cap Rate = (Net Operating Income ÷ Property Price) × 100

  • Net Operating Income (NOI): Total rental income minus operating expenses (excluding debt service).
  • Property Price: The purchase price or current market value of the property.

Example:
A multifamily property generating $100,000 in NOI with a purchase price of $1,000,000 has a cap rate of 10%.

Cap rates provide a way to quickly compare deals, but they aren’t the whole picture. Understanding what drives cap rates and how to interpret them is crucial.

While cash-on-cash returns help factor in the 1st-year return on cash invested including debt, cap rates frame the property as if financing wasn't required (less critical for my purposes but still useful).

What Drives Multifamily Cap Rates?

Several factors influence cap rates, especially for multifamily properties:

  1. Market Conditions:
    • High-demand cities like New York or San Francisco typically have lower cap rates (3%-5%). Investors are willing to accept lower returns in exchange for stability and appreciation potential.
    • Emerging markets like Phoenix or Austin offer higher cap rates (7%-10%) to compensate for growth uncertainty.
  2. Property Class:
    • Class A Properties: Premium, modern buildings in top-tier locations have low cap rates due to steady demand.
    • Class C Properties: Older, less desirable properties in riskier areas often come with higher cap rates to offset greater management challenges.
  3. Interest Rates:
    • Rising interest rates increase borrowing costs and generally push cap rates higher as investors demand greater returns.
    • Declining rates can compress cap rates as competition for properties heats up.
  4. Investor Demand:
    • Multifamily properties are particularly attractive due to diversified tenant risk. High demand can lower cap rates in established markets.

How to Interpret Cap Rates

Cap rates aren’t inherently “good” or “bad.” They need to be assessed in context (relative to one another):

  1. Low Cap Rates (3%-5%):
    • Reflect low risk and steady cash flow.
    • Typical for Class A properties in prime markets.
    • Ideal for conservative investors seeking long-term appreciation.
  2. Medium Cap Rates (5%-7%):
    • Balance risk and return.
    • Found in secondary markets or well-maintained Class B properties.
    • Attractive for investors pursuing both cash flow and growth.
  3. High Cap Rates (7%+):
    • Indicate higher risk but also potential for value-add opportunities.
    • Common in Class C properties or markets with economic challenges.
    • Best for experienced investors comfortable managing complex properties.

Cap Rates in Today’s Market

Recent trends in 2024 highlight how cap rates are evolving:

  • Rising Interest Rates: Multifamily cap rates have expanded by 155 basis points since Q1 2022, reflecting tighter lending conditions. The latest fed rate guidance of just 2 cuts over 2025 caused mortgages to actually spike instead of coming down with their rate cut.
  • Emerging Markets Shine: Markets like Phoenix and Austin offer higher cap rates alongside robust population growth. If I had to guess, these markets are also willing to build housing capacity more quickly, increasing supply.
  • Institutional Pressure: Large funds continue targeting multifamily properties, keeping cap rates compressed in urban cores. Big players moving in means more demand, which suggests fewer opportunities
  • New Supply Surge: Over 440,000 new units are expected in 2024, with an additional 460,000 projected for 2025. This increased supply may ease competition and stabilize cap rates in some markets.

Using Cap Rates Strategically

Cap rates are a tool, not a verdict. Here’s how to use them effectively: Cap rates should be used alongside other metrics like cash-on-cash return or internal rate of return (IRR) for a more complete analysis of a property's potential.

  1. Compare Deals: Use cap rates to benchmark similar properties in the same market. A cap rate significantly above or below the norm warrants closer inspection.
  2. Estimate ROI: Cap rates assume an all-cash purchase and exclude leverage. To assess returns more comprehensively, incorporate financing scenarios.
  3. Assess Risk: High cap rates may signal operational challenges, deferred maintenance, or tenant turnover. Dig deeper before jumping in.
  4. Project Trends: Local economic and demographic trends affect cap rates. Population growth or infrastructure development often signals future compression and appreciation potential.

Whether you’re pursuing cash flow, value-add opportunities, or long-term appreciation, cap rates offer a valuable starting point—but they’re no substitute for thorough due diligence.