Investment Analysis

Beyond Cap Rates

Test assumptions to make informed sale decisions.

Capitalization rates for multifamily properties appear to have stabilized at very low levels after a veritable free-fall in major metropolitan markets since the end of the Great Recession. The drop in cap rates appears to be the result of low cost permanent financing, the perceived long-term stability of apartments as an asset class, and a lack of yield in other industry segments. 

Investors purchase apartment projects in major markets as soon as they are listed - or in some cases before they are listed. The historically low interest rates provided by permanent lenders - Fannie Mae, Freddie Mac, conduits (until recently), and some local and regional banks - make acquisitions at high prices per unit and correspondingly low cap rates feasible. However, going-in cap rates tell only part of the story for long-term investors.

Discounted Cash Flow

Many real estate professionals eschew the use of 10-year discounted cash flow models to value multifamily properties because income and expense growth is typically forecast at a steady pace and because replacement reserves are assumed to be flat through the holding period. It is true that it is simpler to forecast the 10-year performance of multifamily projects than it is to forecast the performance of office and retail over the same period. It is not true that this assumed predictability lessens the need to analyze the performance of multifamily projects over a holding period, especially when comparing apartment projects with varying operating expense structures.

Two stabilized apartment projects may generate an identical net operating income after reserves, but it is the operating expense ratio and the potential volatility of certain operating expenses that will make or break targeted returns.

A Comparison

For example, assume that two stabilized multifamily properties are 94 percent occupied and that each has an NOI of $1,000,000. Property A has an expense ratio of 33 percent (utilities sub-metered) and Property B has an expense ratio of 60 percent (utilities master-metered). Armed with this information, the following basic operating statements can be constructed from the bottom up.

If NOI is capped at 6.0 percent, the value of each property is $16,666,666. Assuming a first mortgage of $13,300,000 (80 percent of the purchase price) at 4.0 percent on a 30-year amortization schedule, the debt service coverage ratios for the properties are 1.31x and the debt yields are 7.52 percent in year one. Both acquisitions require cash equity contributions of $3,366,666 (without transaction costs).

Assume that rents at Property A increase at 2.0 percent per annum and that expenses increase at 2.5 percent per annum over a 10-year holding period. Also assume that rents at Property B increase at 2.0 percent per annum but that expenses increase at 3.0 percent per annum.

 The 0.5 percent increase in annual expense escalations for Property B is an attempt to account for the higher uncertainty associated with the master-metered utilities at Property B. The DSCR for Property A in year 11 is 1.56x and the debt yield on the outstanding principal balance at the end of year 10 is 11.34 percent. The same metrics for Property B are 1.37x and 9.94 percent, respectively.



Additionally, the value of Property A at the end of the holding period, less 3.0 percent for transaction costs, is $17,735,325 using a terminal cap rate of 6.5 percent, while the value of Property B is $15,540,850 (also using a 6.5 percent terminal cap rate) - a difference of almost $2,200,000. Obviously, refinance risk at the end of 10 years is markedly less for Property A than for Property B. Lastly the leveraged pre-tax internal rate of return for Property A is 14.7 percent versus an IRR of 10.4 percent for Property B.

The analysis above is purely “by the numbers” and, by definition, does not include non-quantitative factors. While the slightly higher annual growth rate in operating expenses attempts to take into account the uncertainty regarding the stability of utility costs for a master-metered property, spikes in utility costs would have a dramatic impact on the performance of Property B. As a result, the predictability of Property B's cash flows is much more difficult to assess. Uncertainty is risk and a transaction with enhanced risk should be modeled to generate a higher IRR to an investor. However, as the analysis shows, when the same dollar amount is paid for Property A and Property B, Property B actually yields a lower return - not the higher return that investors should expect.

As this simple example illustrates, investors need to be wary of purchasing multifamily projects based solely on going-in cap rate analysis. The performance of various acquisition targets needs to be analyzed with a focus on operating expense ratios, the allocation of utility costs, and realistic projections for annual rent and expense escalations. Multifamily properties should be modeled over a 10-year holding period to test assumptions and make informed determinations about the value of the future benefits being purchased.


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David L. Church, CCIM

David L. Church, CCIM, is managing director at U.S. Realty Capital, LLC. Contact him at A version of this article first appeared in the Mid-Atlantic Real Estate Journal.

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