What is Cap Rate and Why is it Important?

Cap rate, also known as the Capitalization Rate, is a financial metric commonly used in real estate investment analysis. It measures the relationship between a property's net operating income (NOI) and its market value or purchase price. The formula for calculating cap rate is:

In multi-family housing syndication, cap rate plays a critical role in determining initial cash flows and the profitability and risk of a potential investment. It provides investors with an estimate of the rate of return they could receive if they were to purchase the property “all cash” and lease it out to tenants. The higher the cap rate, the higher the potential cash return on investment, but also the greater the perceived risk. Conversely, lower cap rates are often associated with lower risk, but also lower initial cash flow. .

Cap rate is an important consideration for investors in multi-family housing syndications because it gives us a quick and easy way to compare the potential return on investment of different properties. By comparing cap rates, investors can quickly assess the value of various deals within a given market. It is one input we use to help determine which properties offer the best potential return based on the market value and net operating income.

Additionally, cap rate can help investors determine the value of a property based on its potential income stream. For example, if two properties have the same net operating income, but one has a higher cap rate, it might suggest that the property with the higher cap rate is cheaper and you as the buyer will have to pay less up front for every dollar of net income you will receive from the asset.

Cap rate is also a critical component of underwriting and due diligence in multi-family housing syndication. It helps us assess the risk of a potential investment and determine if it is a good fit for our investment goals. For instance, properties with higher cap rates may offer a greater cushion to service any debt financing, , but also provides . On the other hand, properties with lower cap rates may be less risky but also offer lower returns. Thus, cap rate can help investors balance the trade-off between risk and reward in their investment decisions.

According to CBRE in its most recent US Cap Rate Survey, cap rates are expected to continue rising in the short-term. At Navigator Real Estate, we seek markets with cap rates between 6-7%. Through our research, we’ve seen that this is the most appropriate balance between risk and return.