In a recent post I talked about how Arlington Private Money investors who want to invest in Dallas apartment realty need to understand GRM (Gross Rent Multipliers) and Cap Rates. In this post, I want to clarify what I said and provide prospective Arlington Apartment buyers with more info about how cap rates work when analyzing a potential multi-family real estate purchase.
How Cap Rates Work
Here’s how cap rates work. As I said in my recent post, the cap rate is the net operating income from the apartment investment divided by the market value or purchase price (depending on whether you are buying or selling).
Cap Rate Example for Arlington Apartment Investment
So for example, let’s say we have a $1 million asking price for an apartment project and it has net operating income (or NOI) of $100,000. The cap rate then would be $100,000 divided by $1 million which equals 10%.
Now, if we move the variables in the equation around just a bit, we can see that if we know the cap rate and we know the NOI, then we can calculate the value of the property using the following formula…
Net Operating Income divided by Cap Rate = Value
So, in our example we have NOI of $100,000 and a cap rate of 10%, so $100,000 divided by .1 = a property value of $1 million.
Lower Cap Rates Mean Higher Returns for Dallas Apartment Sellers
Now, what happens if the cap rate goes DOWN? Let’s see…
Say we have a cap rate of 5% with the same NOI as before ($100,000). Then we divide the NOI by the cap rate as follows: $100,000 divided by .05 = a property value of $2 million!
This may seem a littl counterintuitive at first, because the reality is that a lower cap rate yeilds a great property value.
Let’s look at one more example just to be sure we understand completely:
Private Money Investors and Apartment Buyers Should Look For Higher Cap Rates
Say that we have the same $100,000 NOI, but now the cap rate is 16%. Doing the math, we have the following: $100,000 divided by .16 = a property value of only $625,000.
Putting Cap Rates To Use In Multi-Family Real Estate Investment Decisions
So, how can Apartment Buyers use this information to their advantage?
The answer is simple. Buy at higher cap rates and sell at lower cap rates! If you are buying apartments in Arlington or anywhere in the greater Dallas metropolitan area, you are much better off buying at a high cap rate, because that means you will be paying less for the property.
However, when you go to sell your Texas multi-family property, you want to sell it at a lower cap rate, because the lower the cap rate you can sell the property at, the greater the total value you will receive for it will be.
Conclusion
I know cap rates can be a little daunting, but once you start playing with some numbers in the formulas, you will see that you can just use the general rule of Buy High and Sell Low when it comes to cap rates.
