UNDERSTAND I NG POST-PANDEMI C APARTMENT CAP RATES Reporters and analysts often refer to the average “cap rate” or “cap” for a type of property in a given market. For example, they might say, “Class A multifamily in the Denver CBD is trading at a 4-cap”. Exactly does this mean?
Translated from broker speak, this means that all the newer apartment buildings with modern amenities that sold recently in the central business district of Denver were purchased at an average price for which the projected 12 months of net operating income (“NOI”) of each property was 4% of said price (without factoring loan servicing, depreciation or taxes). The translation is a mouthful—jargon is clearly more economical. In mathematical terms, we can define capitalization (“cap”) rates like this:
Another way of expressing cap rates is to say, “For a given property type in a particular area, investors expect to receive a specific stream of income.” Cap rates can be described locally or nationally, for different sectors of real estate and for different classes. With the exception of 2008-2010, we have enjoyed a long decline in national average apartment cap rates over the last 20 years. Indeed, since 2010 the change has been a nearly linear decrease from 7.25% to 5%. All things being equal, if you bought an apartment building for $25 million in 2010 (NOI = $1,812,500) and saw no increase in income, your property in the same condition would be worth
rate compression.” When interest rates decline and large investors continue to have capital to chase deals, in the absence of major risk events, cap rates will fall. In turn, this causes prices of investment properties to rise.
Cap rates are primarily the function of:
Interest rate changes Relative availability of investment capital Varying perceived risks associated with each property type
Average Cap Rate = 12mo NOI / Purchase Price (for all recent transactions of a specific property type and location)
$36,250,000 today ($1,812,500 ÷ 5%).
This is the power of “cap
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