CAP Rate

What it is

Cap rate is NOI divided by property value. That’s the formula. NOI divided by property value equals cap rate.

There are three ways to find the value of a property. Comparable sales — your standard comps, the way you value a single family house. Cost approach — land value plus cost to build new. And the income approach. With multifamily, especially when you get into bigger multifamily, it’s all about what kind of income they make. That’s where cap rate comes in.

The cap rate formula works backwards too. If you know the cap rate and you know the NOI, you can back into property value. If cap rate is 7% and NOI is $28,400 a year, property’s worth about $405,000.

And NOI isn’t just rent. Rent minus management, vacancy, maintenance, capex, taxes, insurance. That’s your actual NOI. Quick math: I figure around 60% of gross revenue. So if a quadplex brings $4,000 a month in rent, NOI is roughly $2,400 a month, or $28,400 a year. There’s your $405K value. And that’s also where the 1 percent rule comes from — a 7-8% cap rate works out to roughly the 1% rule.

Why it matters

On a duplex or small multifamily in a residential neighborhood, comps can still drive the value because owner-occupants will buy those buildings. On 5+ units, it’s all investor buyers running income-approach math. Cap rate is how they’re thinking.

For a B-class type of property, a good cap rate is around 7-8%. That number changes by area. When I first moved out to Tennessee, there were some really rough areas of town — C-class — and I wouldn’t buy unless I was getting a 2% rule. Meaning if it rented for $4,000 a month, I was buying it for $200,000. Sweet deals, but also rough areas.

On the other end, A-class neighborhoods: you’re not going to find 1% rents there. The value is a lot higher than the rents justify because there’s more appreciation potential. You’ll have less than a 1% rule there. These are appreciation plays, not cash flow plays.

Now, interest rates matter too. The 1% rule and the 7-8% cap came from when rates were really low. With rates at 7%, that same cap rate calculation hits differently. You might need a better deal to get the same cash flow.

How it shows up

Cap rate is the pre-screening shortcut for rentals. Before diving into a spreadsheet, a quick NOI divided by asking price tells you in 30 seconds whether the property is even in the right neighborhood for a rental deal.

For a house flipper moving into rentals, you’re usually dealing with single-family or 2-4 unit properties where comps still drive value more than cap rate. But as you scale into small apartment buildings, cap rate starts running the show.

Related

1 percent rule, noi, cash on cash, cash flow, 31 percent rule, duplex