What Are Cap Rates? How Are They Used in Multifamily Valuation?

[Justin Goodin]

Cap rate is short for capitalization rate and is used to indicate the rate of return expected for a particular property. Investors use cap rate to estimate their potential ROI (return on investment) for a particular asset.

In a simplified definition, the cap rate calculates a property's natural rate of return in a single year by dividing its annual net operating income (NOI) by its purchase price. And once calculated, it can be used to compare one real estate investment to another.

Debt is taken OUT of this calculation because it would be nearly impossible to compare different properties with different debt structures. The cap rate calculates the ROI on an all cash basis (hypothetically).

As an investor, you’ll have the ability to evaluate one property’s cash flow against another, as well as measure the potential risk. For example, properties that are older and have fewer credit-worthy tenants may carry more risk, and as a result have a lower price, resulting in a higher cap rate. Diversity of renters, length of leases in place, property condition, and location can also affect risk and value, ultimately impacting the cap rate.

When someone says a property has a cap rate of 5%, or that assets in a given area are trading around a 5-cap, they are talking about the return on that property.