Table of Contents
- 1 Going in CAP Rate Definition
- 2 Going in CAP Rate Formula
- 3 What is the Stabilized CAP Rate in Multifamily?
- 4 What is the Going Out CAP Rate?
- 5 CAP Rate vs NOI
- 6 Frequently Asked Questions About The Going In CAP Rate
- 7 Going In CAP Rate in Apartment Investing - Conclusion
- 8 Interested In Learning More About PASSIVE Real Estate Investing In Multifamily Properties?
Multifamily real estate investments provide a steady flow of revenue depending on how long you choose to hold the investment. However, as a long-term holder of this asset class, you benefit from the vital appreciation element, which yields significant returns upon a liquidity event like a refinance or sell.
As a real estate investor, it’s your job to estimate the property’s fair market value and its terminal value during the underwriting process before choosing to transact on a property. The difference between these two figures is the property’s appreciation value. These estimations can have a considerable effect on the property’s projected returns.
To understand why these projections matter, it’s first necessary to understand a property’s going-in cap rate.
Going in CAP Rate Definition
Going in cap rate refers to a multifamily property’s cap rate within the first 12 months of acquisition. It’s calculated by dividing the Net Operating Income (NOI) during the first year by the initial investment or buying price.
NOI is the gross property income minus the operating expenses. Cap is a before-tax return on investment metric that assumes the property was bought in cash. As we have seen above, the cap rate formula is Net Operating Income divided by the property purchase price. If the purchase price isn’t known, but we have the cap rate, we can rearrange the formula to NOI divided by the cap rate to get the property value.
Property cap rates vary depending on the location and property type. For example, a multifamily property in prime Atlanta will have a lower cap rate than an office building in a smaller tertiary market with much slower growth and less liquidity. A shopping mall’s cap rate may vary depending on the anchor tenant.
What Does It Tell us About Cash Flows?
While the going-in cap rate is a good measure of how the property will perform in the first 12 months, there are some limitations. We can call the cap rate calculation incomplete since it doesn’t have an exact way of predicting future cash flows.
As such, it might be prudent to consider other metrics to get a clear picture of the future cash flow.
Going in CAP Rate Formula
The going-in cap rate formula involves the NOI for the twelve months from the date of property acquisition, also referred to as trailing twelve months (TTM), and dividing it by the property’s purchase price. Here’s what it looks like:
Going In Cap Rate= TTM NOI / Purchase Price
For example, let’s assume a property is expected to generate an NOI of $300,000. The property is going for $5,000,000. The going-in cap rate of the property will be calculated as follows:
$300,000 / $5,000,000 = 0.06
Going in cap rate = 6%
When calculating the going-in cap rate, some real estate investors take the first month’s NOI and multiply it by 12 or three months by 4. Also, keep in mind the purchase price in the formula doesn’t account for the closing costs.
What is the Stabilized CAP Rate in Multifamily?
While cap rate is a good return on investment metric to compare several investment properties, it’s essential to know that not everyone similarly calculates NOI.
Some investors will use a 12-month trailing income, while others will underwrite it through a 3-month trailing income or a hybrid of sorts where they’ll use the 3-month trailing income, but for expenses, use the 12-month trailing. These are referred to as trailing and forward-looking capitalization rates. Slight differences in these numbers can alter the entire cap rate results.
This difference is part of why some investors may be willing to purchase properties with a cap rate of less than 4%. In such a situation, the investor is less focused on the trailing cap rate but on targeting a higher forward-looking cap rate.
This investor has probably written off the acquisition and expects to boost the NOI by raising the rent or reducing tenant turnover. The higher future cap rate is what we refer to as the stabilized cap rate.
What is the Going Out CAP Rate?
Going out cap rate, also referred to as terminal cap rate or exit cap rate, is the return on investment metric used to calculate the returns and their market value at the end of the investment period.
Although it doesn’t have to be to have a successful investment, the investment was likely very profitable if the going out cap rate was lower than the going in cap rate. A lower terminal cap rate means that every dollar of NOI that the property generates annually is worth a higher multiple in terms of its market value. Savvy real estate investors usually seek to invest in housing markets and property types whose market cap rates are expected to compress.
Here are some factors that determine the forecasting of going out cap rates:
- Market Growth: If the local market has a largely expected growth trajectory and a high net migration to the market, you can forecast a lower cap rate.
- Supply & Demand: If there continues to be large net migration to the market and builders can’t keep up with demand, you can forecast a lower cap rate.
- Local Demographics & Economic Drivers: If the market has a growing diversified employment base across several vital industries, you can forecast a lower cap rate.
- Property Vintage: If the property was already 50 years old when you acquired it, apply a small expansion on the Cap rate to factor in the property’s age. This means potentially more deferred issues for the next buyer as some items that make up the property are near the end of their life span. But this may not be much of a factor in a low supply hyper expanding market.
- Tenant Demographic: If the quality of the tenant base is strong, with solid creditworthiness, stable jobs, and enough median household income to support the absorption of future rent increases without significantly squeezing their lifestyle, you can forecast a lower cap rate.
CAP Rate vs NOI
Some real estate investors assume that cap rate and NOI are synonymous. This couldn’t be further away from the truth.
As we’ve seen, the cap rate is a financial metric used by investors to calculate a property’s return on investment. This metric assumes the property is purchased in cash. You calculate a property’s cap rate by dividing its NOI by its purchase price.
Cap rates also vary from one market to another, even while the property type may be the same.
On the other hand, Net Operating Income is a metric used to calculate a property’s gross profits. NOI is all the revenue generated from the property minus all the operating expenses. Other than the rent collected, other sources of income for a property include parking fees, laundry machines, utility fees, and vending fees, to name a few.
A property’s operating expenses are those needed to own and operate the property. These expenses include property taxes, insurance, utilities, management fees, cleaning, and repairs. This net income figure is a before-tax metric and doesn’t account for the debt service payments toward the mortgage, depreciation and capital expenditures.
The NOI formula is simply as follows:
NOI = Revenue – Expenses
As you can see from the cap rate formula, you need to first calculate NOI so that you can divide the result by the property purchase price to get the cap rate.
Frequently Asked Questions About The Going In CAP Rate
A stabilized yield refers to the projected yield of a property once it’s fully stabilized in terms of when that investment property is at a 90% plus occupancy and no longer has any capital improvements planned.
The going out cap rate should be projected to be higher than the going in cap rate to add a layer of stress testing to the deal in your initial underwriting model. This allows the investor to see if the deal still pencils even if cap rates expand x years from the date of purchase.
Stabilized multifamily cap rates vary depending on many factors such as what markets it’s located in, the number of units, the year built, and its amenity package to name a few. Therefore stabilized multifamily cap rates vary, but a typical stabilized cap rate could be somewhere between 3.5% to 6%.
Going In CAP Rate in Apartment Investing - Conclusion
Going in cap rate is a property’s return on investment metric calculated based on the first year’s Net Operating Income and the property’s purchase price but does not include your debt service. Net Operating Income (NOI) is the property’s total revenue minus all the expenses.
Going out cap rate is the reverse of going in cap rate. It’s calculated based on the final year’s NOI and the estimated selling price.
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