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).
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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