If you're considering investing in real estate, you've undoubtedly heard of "cap rate." Investors rely heavily on this metric to determine the potential profitability and stability of a prospective real estate venture. For investors, the question is: what is a good cap rate, and why does this number matter so much?

Fortunately, cap rates are relatively straightforward to understand. Here's what you need to know about them and how you can use them to gauge prospective real estate deals!

What Is a Good Cap Rate?

The short answer to the "what is a good cap rate?" question is about 6%-7%. If you have a cap rate for commercial real estate between 5% and 10%, that's a "good" ROI.

However, as is often the case with investments, the full answer is more nuanced and requires a thorough understanding of what cap rates are and how investors use them.

What Is a Cap Rate?

The cap rate of a real estate investment is simply the net operating income divided by the property's value. 

Net operating income is the total revenue the building generates minus all reasonable and customary operating expenses. Revenues typically comprise rents, but some facilities will have other sources of revenue like advertising spots. Operating expenses included in this formula include utilities, regular maintenance, inventory costs, payroll, marketing expenses, and many more. Operating expenses exclude taxes, interest payments, capital expenditures, depreciation, and amortization. As the name implies, "operating" means all costs necessary to run and maintain the building - not expenses resulting from financing or one-off capital improvements.

As a quick example, let's suppose the owner collects $100,000 in rent per month on a building worth $1 million. To get this $100,000, the building's owner spends $50,000 on day-to-day expenses, like payroll, hiring a lease management company, utilities, etc. They also have a loan on the building with a $10,000 a month interest payment.

Since we exclude the interest cost, the cap rate is ($100,000 revenue - $50,000 expenses) / $1 million property value, or 5%.

That's a good cap rate overall!

However, as is often the case with investing, the entire story is more complex.

Capitalization Rates as a Measure of Risk

It can be easy for investors to focus solely on returns. However, higher returns are frequently an indicator of risk. The reason why Treasury bonds have minimal returns is that they have the backing of the US government. A company circling bankruptcy issues bonds with a 20% return because, well, they might be going bankrupt!

Under this lens, when considering "what is a good cap rate?" the answer depends slightly on your risk profile. A higher capitalization rate usually implies more risk, so even though the return is greater, the risk is also higher that there could be issues. Conversely, a lower capitalization rate means less money but is theoretically more stable investing.

The best way to understand the cap rate as a measure of risk is to think about the formula. Recall that the cap rate is the NOI (net operating income) divided by the property's value. Suppose you have two buildings. Building A generates $100k NOI and is worth $1 million. On the other hand, Building B generates $100k NOI but is worth $2 million.

Building A has a cap rate of 10%. That's amazing! Building B has a cap rate of 5%. That's good but not as good as building A.

If people are only willing to pay $1 million for building A compared with $2 million for building B, that must mean that there are some characteristics of building A that make investors more hesitant to buy it. Or, put another way, that $100k income stream is only worth $1 million, but the other $100k income stream is worth $2 million.

Perhaps building A is in a less-desirable neighborhood where the commercial tenants may run into issues. Or, maybe the region where building A is in has a shakier economy that may result in the companies leasing space going under and being unable to pay. Building A is probably riskier, but it has a greater cap rate. That doesn't necessarily make it a better or worse investment, though.

What Is a Good Cap Rate for Apartments?

So far, the discussion of cap rates has focused primarily on commercial real estate. For apartment buildings, while the definition of cap rate remains the same, the cap rate you should look for is slightly different. What is a good cap rate for multifamily?

On the whole, apartments tend to be a little more stable than commercial investments. Businesses go under and can no longer afford their rent. Residential tenants experience bankruptcy and financial issues, but people prioritize rent payments above everything else, unlike companies. After all, you will be fine if you miss a credit card payment. If you miss a rent payment, you could be looking at eviction, depending on where you live!

Therefore, apartment building cap rates tend to be a little lower. A reasonable cap rate tends to be about 5%. Although, some buildings might be quite a bit less because of where they are. Real estate in Houston or Dallas, for example, is more "secure" than real estate in many tertiary markets. 

Apartment buildings tend to be a little more stable and have more intrinsic value, so their cap rates tend to be a little lower.

Look for Cap Rates that Represent Solid Returns for the Investment's Risk Profile

While there are higher returns than others, ultimately, you want a prospective investment to have a capitalization rate that quantifies the investment's potential risk. A super risky investment with a cap rate of 3% is not a good one to make! However, an ultra-safe investment with a cap rate of 3% might be better for some investors than an ultra-risky investment with a capitalization rate of 10%. Even though the latter investment has a higher return, it might not be the right one for a particular individual or group.

Therefore, before investing in commercial real estate or apartment buildings, consider your risk profile, the potential investment's risk, and ensure the cap rate is reflective of that risk and suitable for you!