Seasoned investors know that finding properties with a good CAP rate, or capitalization rate, is key to financial success. But what is a good CAP rate in today’s ever-changing market of multi-family rental units?
Understanding the Importance of Cap Rates
In general, the higher the CAP rate, the greater the risk involved in the rental property. These properties can represent high returns on your investment, but you could be taking a chance. Properties with a high CAP rate should be part of a diverse investment portfolio; that way, you don’t stand to lose too much if the property turns out to be a real risk.
To calculate the CAP rate of any investment property, divide the net operating income (NOI) by the property price.
Why Rental MDUs Offer Better CAP Rates
Some experts quote national CAP rates at an average of 8 to 12 percent, with the most desirable properties falling below 10. But that average encompasses single-family homes and MDUs (multi-dwelling units).
In general, MDUs possess a much lower CAP rate. That is because your net operating income could fall to zero if a single-family rental unit is empty for any length of time. In a larger apartment building, one or two empty units should not hurt your bottom line as much. You also can earn more in a MDU relative to purchase price.
What Is a Good CAP Rate for a MDU?
With the advantages of a MDU in mind, what is a good CAP rate for a multi-family unit? The average CAP rate was down to 4.3 percent in Q3 2017. The CAP rate for MDUs has been falling steadily since 2012. Anything below this average could be perceived as a very good risk for an investor.
Factors That May Affect CAP Rates
Because the CAP rate is a function of how much a property earns compared to how much it costs, a number of factors affect the CAP rate. For instance, the building’s vacancy rate will affect the NOI.
The building’s condition also can raise its CAP rate. If you spend a lot of money on repairs, your expenses go up and your NOI decreases.
Finally, a building’s location also affects CAP rate. Multi-family apartments in more desirable areas carry lower risk.
Considerations That Are as Important as CAP Rates
The CAP rate, undoubtedly, represents an important figure when considering rental MDUs for investment. But a CAP rate around 5 or 6 percent should not deter you if an apartment seems to be a good risk in other ways.
For instance, before making an investment, consider things like the potential appreciation of a property, the demand for apartments now and in the near future, and signs that an area could be in the early stages of revitalization. To determine if an area is on the rise, consider influencers like job growth, a revitalized downtown area, and the opening of retail establishments and restaurants as evidence of a neighborhood on the upswing.
Pay Less, Earn More
Smart investors will get into the next growing urban region while prices are still low, regardless of CAP rate. By all means, use CAP rate as one of the factors you evaluate when considering your next MDU investment. Just be sure to consider all the variables that make a multi-family unit a good risk before you jump in.
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