This past week we had an aspiring investor ask why are cap rates only used in the valuation of multifamily of 5+ units? The short answer to this question is that going from 4 to 5 units marks the transition from residential to commercial properties. However, to end the explanation here would be a disservice to him or anyone else seeking to understand the potential of commercial real estate investing.
When you purchase a single-family home in which to live or invest, one of the lender requirements you will encounter is an appraisal that matches the price that you are paying for the home. These appraisals are based on comparable sales (known as comps) which are essentially similar houses that have recently sold in the same area. The appraiser can take these sales and adjust for differences between those houses and the one you are purchasing to arrive at a valuation for the property.
When you purchase a commercial property however, the appraisal process looks remarkably different. This is because the primary purpose of commercial property is to produce income whereas the primary purpose of residential is to provide value to the buyer as a home. What this means is that if you make improvements to a single-family home, the only increase in value you can obtain is that which is derived by more perceived value from potential buyers. In commercial property however, the ability to make improvements (which in turn drive for higher rents) not only increases your monthly cash flow, but also dramatically increases the value of the property. The above-mentioned cap rate is the market specific metric that determines how much the value of the property will increase for a given amount of additional net income. It should also be noted that a decrease in expenses in commercial property (that results in an increase of net income) will also increase the value of a property compared to a single family home where it only increases your monthly cash flow.
The difference in valuation of commercial property from residential is what offers a truly astounding investment opportunity to the savvy investor. This is one of the primary reasons why we at Apogee Capital believe so strongly in multifamily as an asset class and believe it provides the best risk adjusted returns for our investors.
There are many important considerations when evaluating a multifamily deal and we make it our mission to careful vet each of these items. If you would like to learn more about passively investing in multifamily, please check out our free ebook "Achieving Financial Freedom Through Multifamily Investing."