What happens to multifamily values if cap rates go up or go down? Why do cap rates impact valuation? Is it material?
How Do Cap Rates Impact Multifamily Valuation?
All investments are valued on a spread to other investments. For example you can buy a 10 year treasury bond which is based on the full faith and backing of the US government for an annual yield of approximately 1.35% in today’s market. If you go searching for other investments that are not backed by the full faith and backing of the US government, the investor will want to be compensated for that additional risk. That’s where cap rates come in. It’s a way to value the relative investment return as compared to other investments.
In the Dallas Ft Worth area today, multifamily properties are typically trading in the 4-5% cap rate range. If 10 year US bond yields rise, then multifamily cap rates will most likely rise also. It’s not always a 1 for 1 change as supply and demand also plays into the equation. For example, let’s assume the US 10 year rises to a yield of 2.5% (an increase of 1.15% from today’s rates). In this instance cap rates on multifamily properties may only rise by 1% or less depending on the supply and demand mix for multifamily property investments.
Cap rates are basically the return an investor would receive if they paid for the investment, in this case the multifamily property, in full with no financing.
Impact Of Cap Rates On Multifamily Valuation
Let’s assume an investor purchases a $10 million multifamily property at a 5% cap rate. The NOI or net operating income for that property would be $500,000. If the investor purchased that property in an all cash transaction with no financing, the investment property is expected to yield a return of $500,000 or 5%.
Now let’s assume the property owner makes no changes to the property, rents and expenses stay the same. The property has a NOI of $500,000 in the first year of ownership. If cap rates drop from 5% to 4%, the value of the property would increase to $12,500,000 ($500,000/0.04) as a new investor would only expect to receive a 4% return on the investment. If cap rates increased to 6% instead, the value of the property would decrease to $8,333,333 as a new investor would expect to receive a 6% return vs the original 5% at purchase.
The above is a very simplified view of valuing properties based on cap rates. There are many strategic initiatives the owner can put into place to force appreciation such as performing interior upgrades and increasing rents or billing back for utilities via RUBS if the property doesn’t already do so. This blog is meant to just show how cap rates can impact valuation, not discuss all the various value add strategies a new owner can put into place. The movement in cap rates up or down can have a material impact on valuations.
Why do I share this story with you?
I share this because some people may not understand the impact of cap rates on their investments. We have been in an interest rate down trend for many many years. If interest rates stay where they are or they go lower, then cap rates will continue to benefit the property owner. If cap rates rise, then cap rates will hurt the valuation of properties and the property owner will have to increase NOI by more than the negative impact of rising cap rates in order to increase property valuation.
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