What is a good cap rate?
The honest answer is that the question is missing a variable. A cap rate is only meaningful against something — a market, an asset class, a moment in the rate cycle. Here is how to find the number that applies to yours.
A cap rate is a price, expressed as a yield. It tells you what the market currently demands to own an income stream of a given riskiness, in a given place. So there is no universal answer for the same reason there is no universal correct price.
What there is: a defensible way to judge a specific cap rate, which is to compare it against what comparable properties in the same submarket have actually traded at, and against what you could earn without taking property risk at all.
Why higher is not better and lower is not worse
This can trip up anyone new to the number, because the arithmetic runs opposite to intuition. Cap rate is income divided by price, so for a given income, the cap rate goes up as the price goes down.
A high cap rate can mean the market is demanding a lot of yield to own that building — because the neighbourhood is thin, the tenancy is short, the roof is old, or the rents are unlikely to hold. A low cap rate can mean the opposite: buyers are confident enough about the income to accept less return for it. Neither is automatically the better buy. The cap rate is the market's summary of how risky it thinks the income is, and reading a high one as a bargain is reading a warning as an invitation.
What it is priced against
Cap rates do not float free. They sit above the return you can get from something with no property risk, and the gap between the two is what you are being paid to take on tenants, vacancy, repairs and illiquidity.
That reference point is the long-dated Treasury yield, published daily by the U.S. Treasury as the Daily Treasury Par Yield Curve Rates. When that yield moves, cap rates tend to follow, which is why a number that looked unremarkable in one rate environment can look generous or impossible a year later. Judge a cap rate against the yield curve of the moment it was set, not against a figure you remember from a different one.
Finding your market's number
Three sources, in order of how closely they will match what you are actually buying:
- Comparable sales in your submarket. The only source that reflects your street, your unit count and your tenant profile. A broker who works that submarket can pull recent trades and the cap rates they closed at. This is the number that matters most and the one you have to ask for.
- Published surveys, for the institutional end. CBRE publishes a biannual U.S. Cap Rate Survey covering major markets and property types. It is built from large commercial transactions, so read it for direction and spread rather than as a figure to apply to a fourplex.
- Your own portfolio. If you already own in the market, your actual operating numbers are direct evidence, and they include the expenses a listing may leave out.
Check the cap rate before you judge it
Before deciding whether a quoted cap rate is attractive, establish whether it is real. A cap rate is only as honest as the net operating income underneath it, and that figure is easy to inflate without anyone stating an untruth.
Four things to confirm:
- Actual or pro-forma? A cap rate computed on rents the seller believes are achievable is a forecast wearing the clothes of a measurement.
- Is vacancy in there? Income stated at full occupancy for a property that has never been fully occupied is a number about a building that does not exist.
- Which expenses are missing? Management, reserves for replacement and the owner-paid utilities are three that are easy to leave out. Each omission raises the apparent NOI and the cap rate with it.
- Has the mortgage crept in? Debt service, income taxes, depreciation and capital expenditure all belong outside operating expenses. Including any of them understates NOI; excluding capital costs from your planning understates what the building will need from you.
Rebuild the operating statement from the raw rent roll and the actual expenses, and compare your cap rate to the quoted one. The gap between them is more informative than either number alone.
When the cap rate is the wrong question
Cap rate assumes a stabilised income stream, so it describes a building that is already doing what it is going to do. It says very little about a property you intend to reposition, where today's income is precisely what you are planning to change, and it says nothing about whether you can carry the loan — for that you want cash-on-cash return and a coverage ratio.