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Understanding Cap Rate

So your looking for an income property and your realtor says this to you: “The commercial property I’m going to show you is a 6-cap, where as this student rental is capping 8%, but will require more of your time.”  What are they actually talking about? Maybe cappuccino or something? No, unfortunately not!

What your rather clever realtor is alluding to is the concept of Capitalization Rates or Cap Rates for short.  The former is a fairly intimidating term and may lead one to believe that many years of post secondary are a prerequisite to understanding this concept.  I’m here to tell you otherwise!

For simplicity, let’s refer to them as “cap rates” from this point forward.  Now, I feel the easiest way to explain cap rates is to express them in the form of an equation.

Value = Net Operating Income/Cap Rate

Since we are more comfortable with what the value of a property means, I like to start here, as shown above.  We can see that the value of a property is the quotient of it’s net operating income (NOI) divided by its cap rate.  To help us understand what this all means, let’s start by defining Net Operating Income (NOI).

NOI – the annual income a property generates after all operating expenses have been accounted for.

Now, let’s go ahead and re-arrange the equation to have the unknown (Cap Rate) on the left hand side of the equation:

Cap Rate = Net Operating Income/Value

We can see that the Cap Rate is derived from the relationship between the net operating income of a property and it’s value.  To put it in even simpler terms:

The Cap Rate of a property is derived from the relationship between how much the property profits annually and how much the property is worth.

It starts to become clear that when speaking of Cap Rates we are discussing a measure of profitability, not necessarily in terms of a magnitude, but rather a percentage.  Thus, Cap Rates are really just measuring the return on investment.

For example, assume you are paying cash for a property to keep things simple.  You purchase a  4-bedroom student rental for $400,000 which generates an NOI of $25,000 annually.  What kind of return are you actually earning?  Simply plug those numbers into the equation and solve for the unknown, in this case, the Cap Rate:

Cap Rate = NOI/Value = $25,000/$400,000 = 0.0625 or 6.25%

Therefore, your property would be earning you a return of 6.25% on your $400,000 investment. 

The more comfortable you become with Cap Rates and the above formula, the easier they become to calculate quickly.  For instance, if you’re looking at purchasing a building for $1,000,000 and your realtor tells you that it is generating around 100k per year in NOI, then you know off of the top of your head that you’re looking at a solid return of about 10%.

So now that you know how to calculate Cap Rates, that only gets you so far.  What dictates a good cap rate from a bad one?  Where is the threshold and why does it exist?

This is where the concept of Risk and Risk Tolerance (which I discussed briefly in my previous blog) come into play.  First of all, real estate clearly isn’t the only investment vehicle available for your excess funds, so we have to look at what other options are out there and the attached levels of risk.

As far as safe investments are concerned, we have to consider the likelihood of default.  If you are buying stocks in a company, there is always the chance that the company could go out of business and your stocks become worthless.  Therefore, size, stability, and capital become important considerations.  It is a widely known fact that your government is a large, stable, and wealthy entity.  Aside from more recent times in Greece, when is the last time you have heard of your Government going out of business per se?  Exactly.

How can you invest in your Government though?  Is that even possible?  Yes, you definitely can and it will become the benchmark for what all other investments are based off of.  Instead of printing more money and degrading our national currency when our Government needs a loan, they look to their fine citizens for the capital instead.  The rate of return isn’t the highest, but you can be sure they will actually pay you back.  Still, how do I loan money to the Government?  They issue Treasury Bills, commonly referred to as T-Bills.  These T-Bills have a face value of say $1,000 and an attached return, depending on the current economy, of around 3.5%. 

So, you buy a T-Bill for $1,000 and a year later you get back your $1,000 plus $35 in interest.  Not too impressive right?  The more you invest, the better it sounds though.  Invest $1,000,000 in T-Bills and you get a nice cheque for $35,000 at the end of the year.  It is far from the best return you can receive on a million bucks, but that is of course a product of the level of risk.  In this case you are essentially taking no risk by investing in the Government and you receive the lowest return as a result.

To get back on topic of what dictates a good cap rate and why this threshold exists, it all comes back to risk.  T-Bills have no risk, so they are the benchmark for risk.  Any perceived risk (i.e. time constraints, upcoming legislation, unproven results, market volatility, etc.) will add a risk premium.

For instance, in the student rental example above where we were capping 6.25%, the risk premium would be calculated as follows:

Risk Premium = Cap Rate – T-Bill Rate = 6.25% – 3.5% = 2.75%

In this case, the market has determined that based on the risks involved in investing your money in a student rental rather than T-Bills, you need to earn 2.75% more annually on the amount you invested to be willing to take that risk.

Now although student rentals are what the average individual predominantly looks for with respect to real estate investments, they actually only comprise a small portion of the real estate investment sector.  Aside from renting residential houses/condos to students/young professionals/families, there is a whole commercial counterpart to real estate investment.  When investing in commercial real estate, you will generally decide whether you want to invest in Retail, Office, Industrial, Multi-Residential, or a Mixed-use property.  Each of these sub-sectors of the commercial real estate industry will have an attached “market cap rate.”  This means that given the characteristics of investing in each individual industry, the market has somewhat determined what risk premium over and above T-bills will be attributed to that commercial sub-sector.  Obviously the riskier the industry, the higher the return one would expect.  Moreover, the location and class of the building (A,B,C) will also play a factor, as better locations in big cities and high-end Class A office buildings for example, will fetch lower returns since their premium attributes are perceived as less risky (easier to rent, easier to sell, better likelihood of Tenant’s businesses succeeding, more appreciation over the holding period).

Generally speaking, investors tend to be content with a solid property that is capping 7% or higher.  That threshold seems to fairly present in the commercial sector and although it’s impossible to say for sure, it could be due to a couple of different reasons: (1) investors see the average commercial endeavour as twice as risky as T-bills, or (2) investors could alternatively put their money in AAA corporate stocks which pay dividends to the tune of 7-8%, but when taking into consideration the property appreciation with commercial investments on top of the annual cap rate, they produce marginally better returns when capping 7% or more, as appreciation will add on an extra few % per year to end up at an average of say 10% per year over the holding period.

In my experience selling investment properties in Guelph, Cambridge, and Kitchener-Waterloo, the 7% threshold does stand pretty true.  That being said, there are obvious exceptions to the rule and reasons why an investor may require a higher cap rate or be willing to accept a lower cap rate as well.  For example, owning a premium retail plaza on a busy intersection is about the pinnacle of retail investments.  In this case, the plaza is usually formed around a few anchor tenants (i.e. large, reputable chains like LCBO, Shoppers Drug Mart, TD Bank, McDonalds, Food Basics, etc.) and then some smaller units are leased at a premium rate to smaller businesses.  The key with these investments is that they are quite safe due to the long term leases and financial stability of the large anchor tenants, the premium rates paid by smaller tenants, the ideal location constantly driving traffic into the businesses, as well as the property appreciation of such a key site within that city.  Additionally, a strong Tenant Mix reduces risk because when the retail clothes industry may be slow, the alcohol industry may be booming (i.e. hard economic times reduce spending on clothes, but drinking goes up to deal with stress).  Just like mutual funds, the more variety you have as far as Tenants, the safer the investment, since there is less likelihood of default overall – spreading out the risk. In this case, investors are willing to accept cap rates in the 5 – 5.5% range I have consistently found within my career.  Unfortunately, these properties are generally all owned by REIT’s (real estate investment trusts) as part of their portfolio which pension funds typically buy stocks in to grow their fund.  On the other hand, an old industrial building that has low clear ceiling heights, outdated lighting, inefficient HVAC systems, and poor shipping logistics may have a net operating income of 7% of the asking price of the property, but investors will discount the state of the building and expect an 8.5 – 9.0% cap rate to purchase such an obsolete building.  This means that if the income remains the same, to achieve a higher cap rate, they must purchase the building for a lower figure in which the net income represents say 9% of the cost of the building, rather than 7%.  In this case, if they were asking $1,000,000 for the property and marketing it as a 7-cap, the net operating income would be $70,000 annually.  However, the savvy investor realizes after viewing the building that it is obsolete for many current industrial users who require higher ceilings for cranes and racking, as well as want high efficiency HVAC systems to keep utilities costs low, not to mention the building will sell for less down the road if capital is not put into fixing these issues.  When accounting for these shortcomings, the investor needs to see a 9% return instead of a 7% return.  The only way to see a higher return with a fixed income of 70k per year is to pay less for the property.  A simple calculation using our Cap rate formula shown below will let the investor know the maximum he is willing to pay for the building to achieve his desired return:

Value = NOI/Cap Rate = $70,000/0.09 = $777,778 (rounded)

It becomes clear that the investor needs an almost quarter of a million dollar price abatement to make this investment financially feasible given the characteristics of the building.

All-in-all, it is one thing to understand how to calculate a cap rate and another thing to truly comprehend how the real estate market operates to determine these cap rates.  Numbers can be artificially inflated due to manipulated balance sheets and income statements.  Buildings could appear to be in good condition, but be obsolete in ways only a professional would notice.  The location and excess land may even appear to be an amazing opportunity to build upon, until your realtor advises you that the City’s Official Plan has designated that it be expropriated in 5 years down the road in 2021.  This again is why it is ever so important to enlist the expertise of a real estate professional with commercial and residential experience to make sure any and every investment you make is a good one.

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