Real Estate Concepts - September 19, 2024

What Is a Good Cap Rate?

September 19, 2024

Abby Blumenfeld
By Abby Blumenfeld

What Is a Cap Rate?

Cap rate is short for “capitalization rate.” It’s a key metric that real estate investors use to analyze potential investments and objectively compare one with another. Knowing a property’s cap rate helps you assess the risk as well as the potential return on investment (ROI). As a real estate investor, you will use this metric to both identify a good investment opportunity and determine property management effectiveness for your existing portfolio.

What is a good cap rate? This is a great question, but it has no one right answer. Like so much in real estate investing, it’s all about context. Understanding the cap rate of a property can help you manage risk and steer clear of high-risk low reward investments, but what is considered a good cap rate? This article takes a close look at several potential answers.

Cap Rate Definition

The formula for calculating the cap rate is straightforward:

Cap Rate (%) = (Net Operating Income / Current Market Value) * 100

The capitalization rate, or “cap rate” of a real estate asset is the ratio of net income to purchase price or fair market value. In practice, cap rates factor into several key dynamics of a real estate investment:

  • Potential cash flow
  • The risk inherent in the property and/or market
  • The total return potential of the asset

How Do You Calculate a Cap Rate?

Fortunately, a real estate cap rate is easy to calculate, so much so that eventually, doing cap rate calculation in your head will become second nature.

Start by finding your net operating income (NOI).

Gross income – Operating Expenses = NOI.

Next,

NOI / Purchase Price = Cap Rate.

Cap rate Formula

Let’s look at an example of how you might use the cap rate formula.

Last year, you purchased a fully occupied quadruplex called Marvin Gardens for $1,000,000. Your gross rental income was $70,000. You lost one tenant in August unexpectedly and didn’t get a new one until October. Your expenses were $15,000.

  1. $70,000 (gross income) – $15,000 (operating expenses) = $55,000 (NOI)
  2. $55,000 (NOI) / $1,000,000 (purchase price) = 5.5% Cap Rate

Your cap rate for last year was 5.5%. Is this a good cap rate? It could be. There is more to the story than a single number, as we will see. If you are investing fractionally via a platform like EquityMultiple, you aren’t actually buying Marvin Gardens on your own. However, it’s important to look at the assumptions regarding the property’s cap rate provided by the sponsor. Movements in cap rates across the term of an investment can have major implications for cash flow and total return potential.

Why Is Cap Rate So Important for Real Estate Investors?

A commercial property with a lower cap rate means lower risk, while a higher cap rate typically comes with higher risk (such as age or inferior location). However, just like a savings account, the rate of return can be so low that there is no profitability or cash flow.

Somewhere in between, investors hit that elusive sweet spot — just enough risk to generate an acceptable reward. Cap rates are also a good tool to compare the pricing of your properties to comparable sales.

Real estate investing is much about understanding return potential versus risk. “What is a good cap rate” is likewise a question of whether the cap rate adequately captures the risk inherent in the property and the market.

The highest cap rate doesn’t necessarily equate to the highest potential risk-adjusted return. A number of other factors come into play. The trending of cap rates within a given CRE sector or market are key. If you can confidently forecast that a property’s cap rate will go down over the term of the investment, and rents at the property stay at least as high, your selling price is therefore higher than your purchase price. In other words, a lower “exit cap rate,” all else being equal, bodes well for investors.

Cap Rate Compression

Speaking of exit cap rates, “cap rate compression” is a critical concept for commercial real estate investors. Cap rate compression essentially means “all else being equal” reduction in cap rates. While a cap rate for an individual property will typically increase over time due to asset depreciation, the market-determined value of the asset could increase over time without any change to rents at the property. Cap rate compression throughout the term of an equity investment means that investors can potentially harvest greater returns at exit, as the exit price has improved relative to rents. Cap rate compression could result from macroeconomic or microeconomic factors.

Cap Rate Compression Definition

Rising real estate asset prices or fair-market valuations without corresponding increases in rental income. In other words, asset-price driven reductions in cap rate.

Why might cap rates go down? “Cap rate compression” can result from both macroeconomic factors or trends in local markets.  

Drivers of cap rate compression

  • Decreases in interest rates (which therefore lower cost of capital and drive up property values)
  • Other macroeconomic factors, namely in aggregate demand and supply. For example, an expected thinning of the multifamily supply pipeline in the coming years could lead to cap rate compression
  • Improvements in the local market, such as from net in-migration or a strengthening of the local economy
  • Improvements to the market valuation of the property, from improved marketing or “curb appeal” for example

Note that even without meaningful cap rate compression, operators can engineer higher exit pricing for the property by increasing rents. Therefore, projected rents in the market are important to consider alongside prevailing cap rates.

A low cap rate doesn’t necessarily mean an unappealing investment. Remember that cap rates also serve as a measure of risk: a lower cap rate means that the market perceives the asset and the market as relatively safe. Acquiring properties at a low cap rate is generally associated with the “core” or “core plus” real estate investment strategy. These strategies generally entail less risk and less upside potential. Depending on other factors, a low cap rate investment can still offer attractive risk-adjusted returns.

What’s a Good Cap Rate for Multifamily Investments?

For most property types, a good cap rate is around 8-10%. Again, it is all relative and other factors matter in terms of anticipated risk-adjusted returns. However, this range of cap rates is generally what is viable in the market given current interest rates and the imperative of positive leverage for real estate sponsors. 

From cap rates to distribution waterfalls, there is a lot to know about commercial real estate. Sometimes you need a trusted guide.

There is no hard and fast rule when it comes to determining a good cap rate — take multifamily for example. Multifamily investments often have a lower cap rate compared to other properties since they offer a consistent stream of income, less perceived risk, and more resistance against market fluctuations. That doesn’t mean you can ignore cap rates when it comes to multifamily, more so that it is just one factor to consider.

The Current View

The rapid rise in interest rates throughout 2022 and 2023 drove down transaction volume and real estate valuations. Eventually rates settled at the highest level in two decades. Then on September 18th, 2024, the Fed opted to reduce its benchmark rate by half a percentage point (50 basis points) while signaling further rate cuts, pending macroeconomic dynamics.

Assuming we have reached terminal interest rates for this cycle, the current rate environment potentially creates an opportunity for profitable real estate equity investments. Higher cap rates mean an opportunity for “cap rate compression” — selling an asset at a lower cap rate relative to the same level of rental income. Now that rates have begun to fall, this possibility seems more immediate.

A different way to say this: interest rates have gone up rapidly. Real estate values have dropped accordingly. Since average rents in many markets and sectors have not changed much, this means (by definition) that cap rates have gone up. Cap rates and interest rates are intimately linked. The opposite is also true: when interest rates drop, valuations tend to increase. Hence this moment offers a period when investors may be able to “buy the dip” in terms of CRE asset valuations and benefit from cap rate compression. But, with the latest moves by the Fed, this window of opportunity may be closing before long.

Historically, a good cap rate for multifamily is over 4% and could be as high as 10%.2 That range comes down to the fact that several factors can influence a good cap rate and possibly make a low cap rate look better or a good one look worse than it is. Interest rates are an important factor in assessing cap rates.


“With cap rates having widened to drive a ~20% decline in multi-family valuations (per Green Street Data), the currently strong sector fundamentals provide an opportunity to investors to capitalize on assets with an appealing basis in strong markets, that could still benefit from additional rent growth and/or cap rate compression.” 

— Charles De Andrade, CAIA, Associate Director of Investments at EquityMultiple

Again, “cap rate compression” is a timely concept. Total return is a function of income as well as asset appreciation. Successful real estate investors will acquire assets at a favorable basis (low price given market factors) and sell at a higher price, usually after making improvements. Mathematically, if income stays the same over the lifetime of an investment, but the cap rate goes down, the asset value (and hence exit price) will have increased. Hence, the recent rise in cap rates brings an opportunity to achieve cap rate compression and, hence, total return.

what is a good cap rate

Cap rate aggregated from apartment REIT valuations as of October ’23. The average nominal cap rate has increased by 50 bps (half a percentage point) since earlier in 2023.

Through our research, we believe there are several factors that primarily influence what a good cap rate looks like:

Asset Vintage

Properties are broken into three classifications based upon the property’s age. As a general rule, an older property costs more to maintain with the potential for a significant expense any given year, raising the costs and lowering the cap rate. For example, Class A is less than 10 years old, while Class C would be 30 years or older.

Asset Location

Some cities have higher costs of living and doing business. Higher property taxes, operating costs, vacancy, and investor demand can influence a location’s potential cap rate. For example, the cap rate you might expect in Los Angeles may be below 4%, while Memphis should be closer to 10%.

Location is broken into tiers so as not to be confused with asset vintages:

  • Tier I properties are located in more desirable cities and tend to have lower cap rates.
  • Tier II is growing fast and has the potential to become Tier I, but for the time being, the cap rate is still good.
  • At the other end of the spectrum, a Tier III is in an economically strong but not yet overpriced city. These tend to be smaller up-and-coming places.

We bring your attention to the fact that Tier I has lower cap rates since you might expect the tiers to move in the other direction. Tier I’s are at the top because despite having lower cap rates, they also have higher value properties and low vacancy rates because a great rental is a hot commodity.

Moreover, JPMorgan Chase states that properties in popular and stable locations within a city generally command lower cap rates. By contrast, areas going through transitions—or on the outskirts of a city—usually have higher cap rates, reflecting greater employment instability and fluctuating demand. Such conditions can lead to more frequent tenant turnover, higher leasing expenses, or other factors that negatively impact the property’s operating cash flows.

Asset Class

Cap rates differ among asset classes (property types) throughout different stages of the economic cycle. According to JPMorgan Chase, multifamily and industrial real estate showed the lowest cap rates in the market as of February 2024. The importance of different economic indicators depends on the asset class: for example, income levels significantly impact residential and retail properties, whereas consumer spending on long-lasting and consumable goods particularly affects industrial real estate.

The variance of cap rates among asset classes is due to multiple factors, including the asset class’s core characteristics, expected future performance, and market conditions.

Going-In vs. Going-Out Cap Rates

Real estate investments usually focus on an exit event, typically a sale. Projecting a future sale price depends on how net operating income (NOI) can be increased and how cap rates in the market will move between the acquisition and sale of a property. The expected sale price of an asset at the end of a hold period is often very sensitive to minute shifts in the going-out cap rate. The more NOI increases and the cap rate decreases over the lifetime of the investment, the higher the sale price. The higher the sale price, the better the return of the investment. Hence, real estate investors take great care in forecasting “going-out” cap rates. It’s typical to forecast the going-out figure equal to or higher than the going-in, all else being equal. This is because as buildings age, they usually become more risky and less able to sustain growing rents.

 

IRR Differentials for 4 Different Exit Cap Rate Scenarios
The compounding effect of NOI means that exit cap rates have less impact the longer the hold.

However, if market conditions improve over the lifetime of the investment, the cap rate will fall, all else being equal. The operator may also be able to enter a more desirable comp set through capital improvements to the property, which could also lower the exit cap rate. This is top of mind in late 2023 and beyond following a period of aggressive interest rate hikes. Commercial real estate values have fallen and cap rates have increased in many markets for the first time in a cycle. This means that we may be seeing more opportunity for cap rate compression (and hence improvement in net IRRs, all else being equal) than in prior years.

EquityMultiple’s dedicated Asset Management Team  takes a proactive approach, including reacting in a changing interest rate environment. Given the linkage between cap rates and interest rates, this proactive approach can potentially help investors seize on favorable cap rate dynamics.

The Bottom Line: The Strategic Advantage of Understanding Cap Rates

In conclusion, cap rates are a cornerstone of commercial real estate investment analysis, offering insights into the potential return and risk of property investments. Keep in mind that capitalization rates do not tell you the full story of an investment thesis. A higher cap rate may imply risk, whereas a low cap rate may imply a quality asset in a stable market, which could yield a favorable risk adjusted return. By mastering the calculation and implications of cap rates, investors can make more informed decisions, strategically positioning their portfolios for success. EquityMultiple’s commitment to investor education and empowerment through knowledge of cap rates and other critical metrics underscores our dedication to your investment journey in the commercial real estate market.

By integrating cap rate analysis with comprehensive market research and due diligence, EquityMultiple offers investors a nuanced understanding of each investment’s potential. Our focus on transparency and education ensures that investors can navigate the complexities of cap rates with confidence, aligning their investment choices with their financial goals and risk tolerance.

For instance, EquityMultiple’s platform features properties with varying cap rates, allowing investors to diversify their portfolio across different risk-return profiles. By providing detailed property analyses, including cap rate calculations, market comparisons, and growth projections, we enable investors to make well-informed decisions tailored to their investment strategy.

EquityMultiple Can Help You Invest

Many want to access investments with diverse risk/return profiles with shorter return timelines, but too often the perceived entry point feels out of reach, both in terms of time and money. EquityMultiple gives you a practical way to invest in multifamily properties from sponsors who know what the cap rate tells them.


Register for a free account to view investment offerings exclusively available on EquityMultiple.com

FAQs — What Is a Good Cap Rate?

What is a good cap rate for a given investment property?

There’s no one answer. Cap rates should be evaluated versus market comparables and considered in the context of projected exit cap rates, interest rates, and project financing. Generally, cap rates between 5% and 10% are considered attractive, but this range can shift based on specific investment goals and market dynamics. It’s essential to evaluate cap rates in the context of the overall investment strategy and market conditions.

What are prevailing cap rates in multifamily?

Cap rates vary by market and asset vintage as well as class. Marcus & Millichap reported in Q3 of 2024 that the average cap rate for multifamily trades between July 2023 and June 2024 rose to 5.8%, which was a 110 basis point increase from 2022’s all-time low.

How do I tell if a cap rate is good?

Take a careful look at market comps and exit cap rate projections. If you have questions as a passive investor, be sure to ask questions. EquityMultiple’s Investor Relations Team is always standing by — ir@equitymultiple.com

How does property location affect cap rates?

Property location significantly impacts cap rates, with properties in high-demand, low-risk areas typically exhibiting lower cap rates due to higher property values and perceived stability. Conversely, properties in higher-risk or less developed areas may have higher cap rates, reflecting a different risk-return balance. Investors should consider location as a critical factor in their cap rate analysis.

Can cap rates predict the success of a real estate investment?

While cap rates provide a snapshot of potential return and risk, they should not be used in isolation. Successful real estate investment analysis incorporates cap rates alongside other financial metrics, market trends, and property-specific factors to build a comprehensive investment picture. A holistic approach to investment analysis is key to predicting success.

Market trends, such as interest rate movements, economic growth, and real estate supply-demand dynamics, can influence cap rates. For example, rising interest rates may lead to higher cap rates, reflecting increased borrowing costs and potentially higher risk. Investors should monitor market trends closely to understand their impact on cap rates and investment opportunities.

Why are cap rates important for accredited investors?

Cap rates offer accredited investors a quick, comparative measure to assess the potential return and risk of different real estate investments. Understanding cap rates enables investors to make more informed decisions, aligning their investment strategies with their financial objectives and risk tolerance. Knowledge of cap rates is essential for navigating the complexities of the CRE market and maximizing investment potential.


1 Source: Forbes, November 1, 2018.

2 Source: 2ndKitchen, May 21, 2020.

3 Source: CBRE U.S. Cap Rate Survey H2 2021, March 7, 2022.

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Abby Blumenfeld
Abby Blumenfeld
Abby Blumenfeld is the Senior Investor Relations Analyst at EquityMultiple. Originally from Massachusetts and a graduate of Quinnipiac University, Abby has an extensive background in both commercial and residential real estate. Before joining EquityMultiple, she gained experience working with commercial properties at Cushman and Wakefield. Her experience includes both the New York City and Boston real estate markets. At EquityMultiple, Abby is responsible for developing relationships with prospective investors, ensuring clear communication, and serving as the primary point of contact for investors. If you reach out to EquityMultiple, there’s a good chance you’ll interact with Abby during your journey. Outside of work, Abby enjoys playing pickleball, tennis, and traveling.

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