If you’re in the hunt for a multifamily investment property in California, understanding the importance of cap rates in evaluating a potential acquisition is absolutely critical to your success. Many folks in the rest of the country view California as a world of its own- socially, politically, and culturally. This schism between the rest of the country and the state is also present in the multifamily and commercial real estate markets- a cap rate that is good in Omaha or Tallahassee might not be so great in the Golden State, and vice-versa. Let’s find out why.
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What is a Good Cap Rate?
The cap, or capitalization rate, is used by commercial and multifamily real estate investors to indicate the expected rate of return for an investment in a real estate property. This rate is determined by taking the expected net income for the property and dividing it by a given property’s asset value, which is expressed as a percentage. Investors use the cap rate to determine their potential ROI before deploying capital in a real estate investment.
The formula for calculating the cap rate is as follows:
Capitalization/Cap Rate = (Income-Expenses) / Cost
When is a Cap Rate Used?
Investors use this formula when evaluating multifamily properties. For instance, let’s say a property has a fair market value of $1 million, annual expenses of $39,000, and an expected yearly rental income of $110,000.
($110,000-$39,000) / $1,000,000 = 0.071
Cap rates range anywhere between 4-10% , but this depends on where we are in the market cycle, geographic location, condition of the property, and the balance between supply and demand in a given area – typically, you want to see higher cap rates in areas with less rental property demand, but every situation is different. Cap rates are important, but they should be considered as a part of the entire picture, rather than a solitary indicator of the potential success or failure of an investment.
Related: Understanding Your IRR and Cap Rate
What Influences Multifamily Cap Rates?
In simple terms, the cap rate is a function of the risk-free rate of return with an added risk premium. In the finance world, the risk-free rate is the theoretical rate of return assuming no risk of financial losses. In the real world, every investment, no matter how safe, carries some measure of risk. As there are no “risk-free” investment classes we can use to explain cap rates and commercial real estate, we can substitute in US Treasury bonds, which are about as close as an investor can get to “risk-free” in real life.
Let’s say you have a million dollars with which to invest, and 10-year treasury bonds are yielding 3% each year. Your million-dollar investment will earn you $30,000 every year while you sit back and relax. However, let’s also say you are not thrilled just barely beating inflation, and you want to compare the potential risk vs. return of a commercial real estate investment property with much higher returns than your treasury bond.
If we assume that the acquisition cap rate on the potential investment property is 6%- this means that the risk premium is 3% over the risk-free rate. This premium represents any additional risk you may assume above “risk-free” treasuries. The risk premium is made up of several variables, of which we will get into in more detail in the next section.
What Factors Influence Multifamily Cap Rates?
Each year, several real estate firms collect and analyze statistics that track cap rates across commercial real estate markets, classes and segments. Through the use of these statistics, many commercial real estate observers try to deduce where the market will be in the future, as well as isolate and study the variables that contribute to rise or fall in cap rates. Several of these variables are critical for determining the true cap rate of a property, including location, market, employment rate, household incomes, asset types, and interest rate changes.
Let’s take a look at each of these categories to see how they influence multifamily/commercial real estate cap rates.
Location has a tremendous impact on cap rates for commercial and multifamily properties. For commercial tenants like those who lease in shopping centers or office parks, properties that are centrally located and near urban economic centers or high-flying suburbs offer the traffic and accessibility they need to thrive.
The same principles apply to multifamily real estate- properties that sit near employment opportunities, entertainment, and lifestyle options can command higher rents due to their attractiveness to renters. Properties within such areas have reduced investment risk due to high-demand and constant cash flow, which are much easier to foster in a prime location, and so these types of locations tend to deliver lower cap rates.
Location and market hit many of the same notes when it comes to cap rates, but it is essential to consider each category individually. For instance, let’s say you want to purchase a multifamily property in an area with less demand for housing, perhaps due to challenging economic circumstances, or a glut of recently built housing. Those areas will have higher cap rates, offering better nominal returns, and lower pricing overall. A property in an area with high demand will likely have a lower cap rate than a property in a less popular area, and so because risk in these higher demand areas is lower, the yields are commensurately lower and the price will be higher.
Looking at the designated market and current available inventory can give investors a better understanding of their potential place in the market, to better understand the risk/reward equation for a multifamily investment.
Positive employment statistics in a market correlate strongly with cap rate compression, which can be a positive quality. It may indicate that prices are on the rise and that some investors perceive real estate assets in that area as having lower risk compared to other investment avenues.
Local job growth tends to compound and build momentum and savvy players in the commercial real estate market can often scoop up off-market opportunities by seeking out markets with high employment growth and low compression. Markets with further room for cap rate compression as employment opportunities grow may also offer the possibility of risk-mitigating spreads during time when interest rates are on rising.
High household incomes usually result in a lower cap rate. For instance, let’s say you purchase a property in a prime part of the San Francisco Bay Area, like the SF Financial District or the Oakland Hills. This area is a large, dense metropolitan area, with a robust and growing economy, and consequently, it has significant ongoing housing and property demand from real estate buyers and renters with high-incomes.
The creditworthiness of tenants and buyers reduces the risk in a market, thus lowering the cap rate for high household incomes, and increasing it for lower-income neighborhoods. Investors are willing to take lower returns in exchange for lower chances of taking a loss on a given commercial or multifamily investment.
Property type has a tremendous impact on where the cap rate falls, and what exactly constitutes a “good” cap rate for investment purposes. Commercial properties can be residential, like multifamily, or for other commercial purposes like industrial facilities, office parks, and retail centers. In most cases, investors are looking for property types that offer stable cash flow- like rents from tenants- as well as manageable, predictable, and stabilized ongoing costs.
Different property types fare well during changing economic tides. A multifamily property or self-storage facility may do better during a downturn as people downsize their homes- conversely, a shopping or retail center might see reduced tenancies and other problems when the economy is not doing so hot.
Interest Rate Changes
In the United States, interest rates and cap rates share a statistical relationship where one closely follows the other, as you can see from the CBRE-sourced graph below. As you can see, both rates have been falling since the early 1990s, largely as a result of qualitative easing and the decline in real interest rates over the same time period.
You should also know that cap rates and/or yields, in economic terms, are more closely aligned with real interest rates compared to nominal interest rates. The cap rate is a real rate of interest, which mirrors and relates to the rate of interest banks provide, minus inflation. Real estate investments tend to have a higher real rate of interest compared to banks due to the various costs and risks associated with the sector. There are some cyclical features to the spread of cap rates, but they remain remarkably consistent over the long-term, which illustrates the stable nature of real estate investments over the long run.
Multifamily Apartment Cap Rates in California
Just like cap rates on the national or international level, what constitutes a “good” multifamily apartment cap rate in California differs wildly from market to market and even neighborhood to neighborhood. When compared to other parts of the country, California has among the lowest cap rates for residential property investments, and they are currently sitting at near historic lows for the state.
In 2018, the national average for multifamily infill sat between 4 and 5.26%, while suburban multifamily ranged from 3 to 5.56%. Compare this to major multifamily markets in California like the San Francisco (2.7%), San Jose (2.7%), Orange County (3.0%)– even the highest cap rates in the state are at or around the national average, with San Diego and Sacramento coming in at 3.6%. These low cap rates are primarily a product of the faith that investors have in these markets- most see substantial long-term economic growth in tech, entertainment, financial services, as reducing the inherent risk of an investment in coastal and coast-adjacent regions in the state.
Cash-heavy investors are limited in their investment opportunities due to supply constraints in many areas, and opposition to local development and astronomical land costs prevent a substantial price decline due to demand far outstripping supply. It doesn’t matter whether supply is naturally constrained through a lack of buildable land, or whether it is being constrained by political or resident considerations and concerns- high prices prevent margins from being too fat, and investors in these areas are willing to make that trade due to the perceived safety of a real estate asset in a high-flying region. This is also what allows substantially higher cap rates in areas without as much price pressure- investors trade that safety for the potential gains to be made getting in on the ground floor of an up and coming neighborhood or city.
Remember that California is a massive state, which would be the world’s fifth-largest economy if it was an independent nation. A desirable multifamily cap rate in California looks significantly different in the Financial District of San Francisco compared to downtown Bakersfield or Stockton. What constitutes a “good” cap rate in California is highly dependent on individual locations- 4% would be fantastic for Orange County or Berkeley, but subpar in rural Lodi, Los Banos, or Fresno.
The cap rate is not, and should never be used as the “be all and end all” metric for making an investment decision- take a holistic, multi-factor inclusive approach to the process to ensure that you are making the right decision for your retirement savings or portfolio.
Both multifamily and single-family homes have seen sustained, rapid price growth in California. In some areas like Silicon Valley, The Great Recession was barely a blip, and land and property valuations continue to soar ever-higher, seemingly with no end in sight. This rapid price growth has brought many regions to a point where investors are chasing one-time transactions and generating income upon the sale of real estate rather than the yield, which underpins cap rates.
While markets have basked in low interest rates for more than a decade, the cyclical nature of the housing sector, and the economy as a whole will cause the Fed and lenders to raise interest rates at some point in the future- possibly sooner than many market participants may think.
Consequently, multifamily and single-family properties may see a dropping off of prices in the long-term, with many experts predicting a long-term home price increases to roughly keep pace with inflation. Should this series of events occur, high cap rates will become an even more integral measure of the economic/ROI potential of an investment in commercial real estate or multifamily homes in California.