Capitalization rate, or cap rate, is a measure of a commercial property’s potential return on investment.

If you buy a $1 million multifamily property that has a cap rate of 5%, it generates $50,000 in income annually after operating expenses.

Here’s the formula:

Net Operating Income (NOI) / Value = Cap Rate

Net Operating Income or NOI is the dollar amount generated per year after regular expenses of running the property like management, utilities, and maintenance.

Plugging in the numbers from above: $50,000 / $1 million = 5%

In multifamily investing, cap rate can help you determine added value on your property. Rearranging the formula, we get Value = NOI / Cap Rate. So assume you make improvements and raise rents. Now NOI is $60,000. At the same 5% cap rate, your property value can be calculated as:

$60,000 / 0.05 (5%) = $1.2 million

You just created $200,000 in value by raising NOI by $10,000 per year. (This formula is actually the most attractive thing about multifamily investing.) You can see why it pays to know about cap rates for multifamily property.

What Determines Cap Rate?

Many factors contribute to cap rate, but the easiest way to understand it is as a risk/reward trade-off for an investment.

Typically you get a higher rate of return for riskier investments and very low rates of return for safe investments.

A CD or government bond probably carries a rate of return of about 1% per year. For every $1,000 invested, you get $10 per year. That’s not much, but you’re not risking much either.

Now imagine your shady, couch-surfing cousin says he wants to borrow $1,000 at a 50% interest rate. After one year, you would get your $1,000 back plus $500 in interest. Not bad, until you consider that you’ll probably never see a dime.

The point is, the riskier the property, the higher the cap rate. So a high cap rate on an apartment building might actually be a reason to turn it down, despite high returns on paper.

Most cap rates range from 3-8%, but there’s no reason a property can’t come with a 10 or 20 cap. Let’s look at two scenarios:

Sonoma Apartments: 5% Cap Rate

This property is an an “okay” part of town that is on the rise. It looks a little run down, but the bones are good and it’s about 75% occupied. There’s very little crime in the area and tenants pay their rent on time. It’s not perfect, but it’s a fairly safe investment.

Oak Park Apartments: 12% Cap Rate

This property has some major issues. It’s getting run down, and will need new electrical wiring and probably plumbing soon. It’s not in the greatest part of town, and current management is a bit afraid of some of the tenants. One employer employs about half the tenants, and there are rumors that the company will move operations out of town soon.

Which apartment complex would you seriously consider buying? Most investors, unless very experienced, would buy Sonoma. You won’t make as much compared to the purchase price, but you don’t stand to lose as much either.

Remember that one part of the cap rate formula is purchase price. Properties with very low purchase prices compared to their income have a high cap rate. And usually there’s a reason a property is offered below-market.

Other Things that Affect Cap Rate

The property itself isn’t the only thing that affect cap rate.

Bottom Line

Cap rate is one of the more important terms to understand when shopping for multifamily property. Armed with a good feel for common cap rates in your market, you can make a wise decision when buying.