Understanding Cap Rate in Multifamily Real Estate Investing

One of the most fundamental concepts in multifamily real estate investing is the Capitalization Rate, commonly referred to as the Cap Rate. This simple yet powerful metric helps investors evaluate potential deals, compare properties across markets, and understand risk versus return.

What is Cap Rate?

The Cap Rate represents the expected rate of return on a real estate investment property, assuming it is purchased in all cash. It is expressed as a percentage and is used to compare the relative value of real estate investments.

Cap Rate Formula:

Cap Rate = Net Operating Income (NOI) / Purchase Price

For example, if a property generates $100,000 in Net Operating Income and it’s listed for $1,250,000, the Cap Rate is:

$100,000 / $1,250,000 = 0.08, or 8%

What is Net Operating Income (NOI)?

NOI is the annual income generated by the property after subtracting all operating expenses, but before deducting mortgage payments, taxes, and depreciation. It includes rent, laundry income, parking fees, etc., and subtracts expenses like management, maintenance, utilities, and insurance.

Why is Cap Rate Important?

• Quick Comparison: Cap rate allows investors to compare similar properties quickly.
• Risk Indicator: Higher cap rates generally imply higher risk; lower cap rates suggest lower risk and higher property value.
• Valuation Tool: It helps determine what a property is worth relative to its income.

What is a Good Cap Rate?

A “good” Cap Rate depends on the location, asset class, and current market conditions. In strong urban markets, a 4%–5% cap may be acceptable. In secondary or tertiary markets, 6%–8% or higher might be expected. The higher the cap rate, the greater the return—but also potentially more risk.

Cap Rate vs. Cash-on-Cash Return

Cap Rate is based on an all-cash purchase and ignores financing, while Cash-on-Cash Return considers how much return you get based on the actual cash you invested (including loan leverage). Both are important, but they measure different things.

Limitations of Cap Rate

• Does not account for financing costs
• Doesn’t capture appreciation or tax benefits
• Not useful for properties with irregular or volatile income

Using Cap Rate in Deal Analysis

At Princeton Financial Equity Group, we use Cap Rate as a starting point—not the final decision-maker. We consider multiple metrics such as IRR, Equity Multiple, and projected rent growth. Cap Rate helps us understand current value and return potential based on stabilized income.

Conclusion

Cap Rate is a foundational concept in multifamily real estate, offering a snapshot of potential returns based on income performance. While it’s not the only metric to consider, it plays a crucial role in comparing properties and assessing market value. Investors should use it alongside other key performance indicators for a complete financial picture.

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