To be successful in apartment investing it’s critically important that you understand Net Operating Income and Capitalization Rate and more importantly the interrelationship between the two.
Give me a lever long enough and a fulcrum on which to place it, and I shall move the world
- Capitalization Rate (Cap Rate), and
- Net Operating Income (NOI).
1. Capitalization Rate
Cap Rate is the “market valuation” metric for your property type and grade in a given market. For example B grade apartment buildings in many of our Texas markets trade at a 7.5 to 8.5 Cap Rate range.
In other markets however the Cap Rate could be in a range of 4.0 t0 5.0.
The Cap Rate is defined as the unleveraged annual cash return (as a percentage) for the property before any debt service or capital improvements. So, if you purchased an apartment building for $4,000,000 and it is an 8.0 Cap Rate, you would expect to make $320,000 per year in Net Income.
One analogy is that Cap Rates are a lot like average price per square foot ranges on residential homes. Depending on the location and amenities, the same exact home will have completely different price per square foot values and corresponding home price.
The same is true for Cap Rates.
The exact same property in different markets and in different physical condition can have a materially different cap rate range.
The Cap Rate is basically “The Market” and the owner/investor has very little control over it.
On the other hand, Net Operating Income (NOI) is largely controlled by you, the investor/owner.
2. Net Operating Income
Net Operating Income is the Gross Income (Rents plus other income minus vacancy and collection loss) minus the operating expenses (not including debt).
This NOI is the free Cash Flow the property provides before paying any debt.
Basically, given any two buildings of the same age, location, and condition, the property with the larger NOI is the better asset.
You see, apartment buildings are basically independent small businesses. If you improve operations – marketing, leasing, expense management, collections, etc. -you increase the value.
Some key points to keep in mind:
- Cap Rates, specifically in multifamily apartments, move very slowly if at all. This is great for reducing volatility and increasing predictability.
- Typically Cap Rates for multifamily apartment investments are range based (e.g. 7.5 to 8.5). This is helpful because even if the cap rate in your market increases after purchase, you can increase the NOI enough to compensate for the change and still increase both cash and equity value.
Follow the process below to protect your invested equity and develop permanent wealth.
- Find the best markets for multifamily investing,
- Either be or work with the best Asset Managers you can,
- Find the best operators (professional, certified, fee-based property management),
- Find the best submarkets and neighborhoods,
- Purchase the best asset for your strategy,
- Improve NOI and maintain your capital investments, and
- Collect tax-advantaged Cash Flow month after month.
Follow the process above and you will be well on your way to Achieving Permanent Wealth(tm)
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