Here’s a quick update on why I’ve been absent from my blog and social media. In June of 2023, I broke my tibia and fibula in an accident in Africa and required emergency surgery to insert a long rod into my tibia. This wasn’t the “break” I was hoping for; however, my time off has allowed me to recover and focus on my investments.
If you’ve been following the news, you’ve seen that interest rates have almost tripled since early 2022. Below I will explain the differences between rate caps and cap rates.
So, cap rates and rate caps: they sound similar but are entirely different animals. One helps you figure out if a property is a smart investment, and the other prevents your mortgage payments from spiraling out of control. Each is important in its own way when learning about the multifamily world.
In the multifamily sector, you’ll hear a lot about “cap rates.” This term is basically a quick way to determine whether a property is a good buy. Take the annual income the property could make, subtract the expenses, and then divide that by the property’s cost. This gives you the cap rate.
Higher cap rates usually mean you’re looking at higher risk, but also higher potential profit. It’s akin to the property’s own version of ROI (return on investment). Cap rates vary between markets and submarkets. For example, a 143-unit C-class property in a tertiary market in Iowa will have a much higher cap rate than the same complex in the Dallas market.
Now, let’s say you need a loan to buy that apartment building. Some deals use a bridge loan, which doesn’t have a fixed interest rate; it can fluctuate depending on market conditions. This is where the “rate cap” comes in. It acts as a safety net, limiting how much the interest rate can increase during specific periods and over the loan’s lifetime. So even if interest rates skyrocket, you’re protected from your mortgage payments doubling overnight.
Most bridge loans I’ve seen have a three-year limit, with the option to purchase another rate cap for two years or switch into a fixed-rate loan. If you’ve been investing in the past three years, you’ll know that bridge loans have become popular. However, with rising interest rates, even deals with rate caps may not provide cash flow to investors.
Why do both of these matter? Even as a passive investor, you need to understand how cap rates can influence your investment. Where is the property located? What is the historical cap rate in the area?
When choosing an investment these days, consider whether it’s a bridge loan. Was a rate cap purchased? Is the deal analyzed for worst-case scenarios if the loan’s interest rate increases?