Multifamily Properties – Why the Cap Rate Is Insufficient for Determining Investment Value

By | October 22, 2018

In the multifamily market, the cap rate or “capitalization rate” plays a dominant role in determining the market price of a property. By definition, it is the calculation used to “determine the ability of the property to carry debt as well as for a measure of overall returns” (Miller & Geltner, 2005, p. 298). However, there are drawbacks that render the cap rate insufficient for determining investment value. Firstly, it is limited in perspective; it only looks at the first year forecast of cash flow; it does not take into consideration the impact of financing and taxes (CCIM Institute, 2005, p. 6.6).

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These are important considerations in the overall determination of investment performance. Among investors, it is a “common misconception when using the term ‘cap rate’ that some investors assume the overall cap rate is equal to the return on their invested capital; this is rarely the case” (CCIM Institute, 2005, p. 6.6). Yet, the tradition of investors acquiring properties at 4% – 5% cap rates is keeping the price of properties inflated in certain markets. An investor that buys an apartment building at a 7% cap rate could still find themselves earning very low returns–or losing value–if the property does not cash flow as anticipated. Therefore a cap rate is insufficient, because it does not factor important considerations such as investor preference, capital investment, or material financial information that would impact the performance of a property over the term of the anticipated holding period.

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