Defining Cap Rates

There's a big misconception in multifamily investing when it comes to defining cap rates. Cap rates are nothing more than one of the many avenues for determining value of a property. It is NOT a way to determine your return on investment.

Here's an example:

We have three properties that have a purchase price of $100,000; 

Property A has a projected 1st year NOI of $10,000 and a sale price of $100,000, which gives us a 10% cap rate and 10% Return on Investment, or Internal Rate of Return (IRR). 

Property B has a projected 1st year NOI of $5,000 and a sale price of $105,000, which gives us a 5% cap rate and 10% IRR.

Property C has a projected 1st year NOI of $15,000 and a sale price of $95,000, which gives us a 15% cap rate and 10% IRR.

The relationship between cap rate and return on investment is seen in the examples above. If the sale proceeds are the same as the value (purchase price), then the cap rate will be the same as the IRR; if the sale proceeds are greater than the purchase price, then the cap rate will be less than the IRR. If the sale proceeds are less than the purchase price, then the cap rate will be greater than the IRR.

As mentioned above cap rates are just one of many avenues for determining value. If you're strategy is to reposition a foreclosure then more than likely the rents are low, occupancy is low and there is deferred maintenance. In a case like this cap rate does you no good in valuing the asset. You would be better off looking at comparable properties on a per unit price basis.

On the other hand if your looking for a turnkey property that's producing strong cash flow with market rents and occupancy, then the market cap rate is a good benchmark for determining value. But remember that doesn't mean the cap rate is your expected ROI, especially if you finance the property.