what is the low down on cap rates?

[ryanlake]

I know what the term cap rate retains to= NOI/ purchase price, which is the "cash flow zone" method that REIN uses. But different style properties seem to demand a different standard of these rates, as well as different areas. Can someone shed some light on this and what is essential to know about them?



Also, when properties grow in value, naturally the cap rate gets lower due to the equation. If the number no longer fits the "cash flow zone" once you already own the property, is that relevant or just when you are buying the property?

 

[margaretcowan]

Cap rates in a city do vary from area to area in that city. I found the key is to consult real estate owners or agents with a "street" knowledge of the neighbourhood I'm interested in and find out the cap rate for my type of property. Recent sales of comparable properties in that area show you cap rates but you don't know of any special deals between the buyer & seller which might distort the value.



It's important to keep your rents at market each year you own the property. If you don't, the cap rate gets lower and so does the value of your property when you sell, which is valued on the income it produces.



Cheers

Margaret



Mama Margaret & Friends Cooking Adventures In Italy

www.italycookingschools.com

 

[Thomas Beyer]

[quote user=ryanlake]Can someone shed some light on this and what is essential to know about them?
CAP rate is CAPitalization of the income stream into perpetuity.



As an example, if someone gives you $10,000/month, for life, what are you willing to pay for this ?



It is the equivalent of the P/E ratio in the stock market. A high growth
stock might command a 30-50 multiple (or 2-3% CAP rate equivalent),
where as poor stock might be 8-10 (or a 10% to 12.5% CAP rate
equivalent).



It is a reflection of the reliability of this income stream, i.e. risk. Is it growing ? Is it very variable i.e. up and down due to rent roll fluctuations or vacancies ? How long are vacancies if there is one (much long in industrial or office buildings than apartment buildings, for example) ?Is the city growing with upside or is there negative pressure on rent ? is the building old and ugly and needs lots of work ? Is there a lot of competition from new construction ? How easy is it to replicate this very unique or very average asset ?



Generally, a bigger city with more diversity, high land prices and growth prospects command the lowest CAP rates, whereas a smaller town with only one industry will command a higher CAP rate.



As a rule of thumb in Canada:

around 4% for Vancouver,

5% for Calgary,

5.5% to 5.75% for Edmonton, GTA or Burnaby, Surrey, Winnipeg, Regina, Saskatoon or Halifax

6% for Hamilton or Sudbury or Red Deer or Kingston

7%+ for very small towns



Usually about 2% higher than the mortgage rate, but not always. If it is higher than the interest rate for a mortgage (around 3% these days) it is referred to being "positively geared".



Risk, interest rate, property type, vacancies, quality of area, quality of asset all influence this rate.



Another metric we look for is price per unit and price per square foot of rentable space.

 

[Pheenix]

Your observation is correct that different types of properties and different areas have an effect on the cap rate.



The easiet way to get your head around this are the concepts of the cost of money and risk adjustment.



So, interest rates (ie cost of money) vary over time and therefore this influences cap rates, and therefore valuations in the opposite direction. The experience over the past two decades has been a reduction in interest rates and therefore a reduction in cap rates, for example. Properties sold at a 15% cap in the late 80's are say 6% today, so property values have gone up.



As for the risk adjustment, residential is generally precieved to have the lowest financial risk for investors and therefore the a lower cap rate. Industrial, retail, hotel and resort properties also have different financial risk profiles. Similarly for cities, neighbour hoods and even streets. The number and variety of factors that can influcence cap rates is astounding; general economic conditions, local conditions, medium and longer term situations, political and investor sentiment enter into the equation.



As for a owned property moving out of the cash flow zone, it depends on which way it has moved and why. Either you have an equity gain (cap down) or a loss (cap up). So do you cut your losses (sell), stay the course, refinance and reinvest, deleverage (and with what strategy)? This is why it is necessary to understand the local market, the forces at work in it and to study economic conditions and trends.



Monitor the cap rate from time to time, if you are not too active, but you will be aware of the changes if you are active anyways. They don't tend to change too quickly. The important part is trying to get a handle on why they are changing.

The implications that arise and therefore your course of action, based on your analysis, will vary depending on your situation, objectives and interim goals.



Hope that helps.

 

[GTwinney]

Two questions that I wrestle with a little:

• Do you include property management costs in the equation when calculating and comparing cap rates? Obviously, it is most conservative and better if you do, but wondering if that is the common practice because I don't see properties advertised for sale including property management costs and want to ensure I'm using apples to apples calculations when comparing to market cap rate norms.
  Do you include the borrowing costs (principal and interest, just interest, or ignore completely) of the down payment if it is borrowed (eg if you borrow from your principal residence LOC) when trying to calculate cash flow? Again, obviously better if you do include all borrowing costs, but have struggled to find properties that work when borrowing the entire amount, including the down payment.

Would love some insight and thoughts on these two items.



Thanks

Greg

 

[Rickson9]

I include all costs when calculating operating profit (aka net operating income) except interest and taxes. Sellers don't incude PM costs (as well as other things) because they want to advertise high (fantasy) cap rates to lure in unsuspecting noobs. For me, operating profit usually runs around 50% off gross rental revenue.

 

[Thomas Beyer]

[quote user=GTwinney]Do you include property management costs in the equation when calculating and comparing cap rates?
You include ALL operating costs, so yes, PM costs too.



You do not include financing costs, as the CAP rate is used, among other variables, to arrive at a fair market value of the asset. The bank then lends based on that value and the cash-flow the asset provides, using a DCR (debt coverage ratio) analysis. Usually they want to see a DCR of 1.25 or better, i.e. NOI divided over the mortgage payment (including interest and principal).



Some folks like to buy with more cash-flow, i.e. high down-payment and a lower mortgage, and other folks rather invest less money upfront, have a tighter cash-flow but with usually a higher cash-on-cash return in a rising market over 5 or 10 years [counting the anticipated equity upside on exit]. That down-payment & leverage decision is rather individual, independent of the asset value.



[quote user=GTwinney]Do you include the borrowing costs (principal and interest, just interest, or ignore completely) of the down payment if it is borrowed (eg if you borrow from your principal residence LOC) when trying to calculate cash flow?
The cash required has an opportunity cost, but you do not include that in your cash-on-cash calculations usually.



Of course you also do a 5 year cash-flow analysis, as much cash is required to upgrade the asset while you hold it. That cash comes partially from cash-flow but frequently also from cash reserves, depending on your value enhancement goals or the state of repairs of the asset. A leaky roof might have to be repaired right away, but the ugly hallways carpets can perhaps wait a year or 3.

 

[invst4profit]

I base my calculations on 100% financing regardless of my down payment. My cash, like everything else I own, must earn it's keep. To ignore the value of my cashes lost income simply artificially inflates the value of your investment property.



As Thomas states investors usually do not include the income lost on cash invested but I do as I prefer my accounting to be accurate. This becomes increasingly important as a mortgage is paid down and a property appreciates.



When buying it is best to look for properties that the landlords have allowed the rent to fall behind market value. Landlords that do not annually increase there rents, because they have great tenants, devalue their properties (especially in Ontario).

 

[GTwinney]

Thanks for the comments. I do exactly the same thing and include calculations "as-if" it is 100% financed, regardless of where the money is actually coming from. Obviously, it makes finding properties that throw off positive cash flow under that scenario more difficult especially when your total weighted cost of capital is much higher if you include all of it, not just the cost of 75-80% or whatever you are actually financing.