When people assess the value of a property, they can use one of two very common methods.
The first one is most used in the residential world. It is the comparison method. If I own a 3 bdrm home with 2 baths in a subdivision, the first thing I should know is what other similar properties have sold for in that area. From there, add or subtract based on key features in the home.
As you can imagine, it is a fair way to evaluate a residential home. If the last three homes all sold for $245K, $252K and $255K, there is a pretty good chance your property is also worth $245K-$255K.
The second method of determining value is based on the revenue it delivers. The most common method of calculating that is by CAP Rates.
The CAP, or Capitalization, Rate is defined as the ratio between the net operating income produced by an asset and its capital cost or alternatively its current market value. The rate calculated in a simple fashion is as follows: Cap Rate = annual net operating income / cost (or value)
For example, if a building is purchased for a $500000 sales price, and produces $30000 in positive net operating income (the amount left over after the fixed and variable costs) during one year, then $30K / $500K = 0.06 or 6%.
With it more and more difficult to find safe investment vehicles out there, investors gravitate to real estate. In 2014, investors in the Greater Toronto Area (GTA) are willing to purchase a property that has a much lower CAP rate then they would have been willing to do in 2010. Specifically, in Toronto, where once 6% was the low number, now I’m seeing deals transpire at rates under 4%. Even in Oshawa, where once 8% was acceptable, I’ve seen a couple deals in the past few months sell for well under 6%. Capitalization rates are an indirect measure of how fast an investment will pay for itself. A property with a CAP% of 10% the payback is 10 years. At 6%, it is 16.6 years.
One point I want to make is that debt repayment is NOT factored in, when determining one’s NOI. If it were included, the CAP rate would be much worse on a building that had a mortgage versus another that is owned free and clear. The owner’s property financing must have nothing to do with a property’s worth.
Now, let me share with you the importance of consistently raising your rental amounts. Besides the obvious answer of making more money, it also raises the value of the building. Let me explain. Let’s say you own a property that can be resold all day long with a 6% CAP rate. If you find a way to increase your rent just $10 a month. That works out to $120 a year. To calculate how $120 a year can increase the value of the property, divide the rental increase by the pre-determined CAP Rate. In this example $120 / 6%. That works out to a value increase of $2000. SOOOO, increasing the rent $10 a month raises the value of the property by $2000. Not bad huh. $100 a month, means a property value increase of $20000. If you have the option of doing a repair to a unit and it would cost you $10000 and by doing it, you can increase the rent by $100 a month, should you do it? My answer is that not only will you receive the extra rental money, but you have built double the equity in your building.
“So what”, you say. “That only comes into play when I sell the property”. Not always true I answer. Once you have built enough equity in the building, you can do a bank refinance and get much of your initial investment and/or renovation costs out of the property, while still maintaining a debt to equity ratio that our very conservative banks will accept. The other, more difficult to measure benefit of doing the reno, is that you have the opportunity to attract a more desirable tenant. There are a lot of benefits to having a good tenant.
Although there are other ways to determine a property’s value, these are, by far the two most common.
The next time you read a prospectus and see a listed CAP Rate, you’ll now know what they mean. But one word of warning. The listing real estate agent or seller may not be including all of the actual expenses OR be using projected rental revenues rather than actual numbers. I can show a 10% CAP in all of my properties if I exclude yard maintenance, property management, basic repairs and waste removal. I can also show a zero percent vacancy rate and tell the buyer it is always rented. However, the fact is that these things exist. My advice I like to offer is, get the numbers they provide, then as you are doing the walkthru, look for renos, repairs, rental items, and services that are not included in the operating expenses provided. It is only after you have actual revenues and actual operating expenses can you determine the CAP Rate offered.