If only I knew then what I know now.
In 1994, I brokered the sale by Manulife of a 456-suite apartment building in Kitchener for $18 million. The building’s cap rate was 11%. The buyers politely suggested I invest my commission on the sale back into the building. After weighing my options, I decided not to.
Years and decades went by. Colliers relisted the building in 2019.
This time, the sellers listed the building for $109 million. I lost out on a 506% return. And this time, the property carried a cap rate of only 3.5%.
I’ve always had faith in Canada’s multifamily apartment market, but of course, back then, I wasn’t expecting the market to go on a rocket ship ride. The demand for rental properties is greater than ever and we’re seeing bidding wars for rental units throughout the country.
My lost investment opportunity example highlights what has been happening to the multifamily market as a whole over the past 25 years, as there has been a shift from modest prices and high cap rates to extremely high prices and low cap rates.
The national average cap rate decreased from 4.41% at year-end 2019 to 4.33% at the end of last year, and compressed even further to 4.32% in Q1 2021, according to Colliers’ H1 Multifamily report.
Part of the reason for this trend is that the key players in the market have changed. There’s more money and larger organizations chasing a relatively finite number of buildings while strong demand for urban rental homes has increased and developers and owners are struggling to replace ageing rental stock.
As cap rates continue to decline, it’s important for the industry to look beyond cap rates as the main measuring stick to assess an investment.
Rising rents are a significant contributing factor to the value of multifamily buildings in today’s market so investors should be looking at effective ways to properly manage tenant turnover, leverage higher rents and maintain elevated cash flow when looking at the overall return on investment.
The key players have changed
In the 1990s, the majority of multifamily buildings were owned by private, “mom and pop” style investors. As demand and rents increased, many of these private investors lost their appetite to purchase buildings with high prices and cap rates as low as 3.5%.
Meantime, several large private and public institutions saw plenty of opportunity and value, and the industry evolved towards a professionally run, institutional business model.
The institutions had a lower cost of capital, long-term investment horizons and economies of scale. Then they professionally managed the buildings — and that meant improving the buildings, increasing rents and pushing up values.
Migration is driving the demand for apartments
So what’s driving the demand for rentals?
Canada is planning to welcome 1,233,000 new permanent residents over the next three years: 401,000 next year, followed by 411,000 in 2022 and 421,000 in 2023. We know that many of those newcomers will be living in Vancouver, Toronto and Montreal, and many will be renting.
Population growth and changing demographics are two significant factors putting pressure on the rental market. Immigration into Canada’s major centres is driving rental demand in those cities while the ripple effects of urban growth are pushing and pulling residents into suburban rental homes.
Meanwhile, the pandemic, coupled with affordability concerns and the remote working phenomenon, has caused many Canadians to reevaluate their housing needs and move outside major centres for more affordable housing with increased square footage, simultaneously stoking the suburban, secondary and small city rental markets.
Another ingredient fueling our rental market is our ageing baby boomer cohort. This age group is the wealthiest ever and many of them are now in the process of downsizing into fancier rental properties with more flexible options.
Some boomers are cashing out their properties to give their children and grandchildren financial help to break into our expensive housing market.
Inventory has evolved
Along with the market shift in owners and tenants, rental units and buildings have evolved. Various periods of rent controls combined with a shift towards condo development in our big cities led to a stall in the construction of purpose-built rental buildings during the 1970s, 1980s and 1990s.
As a result, we ended up with an ageing inventory of apartment buildings across the country, causing particular challenges in smaller cities that lack condo development.
But ,times are changing. There has been a resurgence in new, purpose-built apartment rental projects and applications due to the increase in demand for rental units, the need for affordable housing and enticingly high rental rates for owners.
These apartments, which offer higher-quality finishings and condo-style amenities without the responsibility of homeownership, are making the rental market more attractive and lucrative for former owners.
The challenge remains, of course, for owners of existing, ageing inventory to find creative, sensitive and thoughtful ways to upgrade, rebuild and construct new purpose-built rental buildings while minimizing stress and uncertainty for our existing renters.
For those who do it the right way, there are profits to be had regardless of the cap rate.
Cap Rates 101
Cap rates. It’s a bit of industry jargon that can send many to Investopedia grasping for a definition.
Put simply, a cap rate is the net operating income of a property divided by the price. And the net operating income is defined as the rents minus expenses.
So if you had rents minus expenses of $100,000, that would mean at the end of the year you would get $100,000 as the owner of the building. And if you paid $1,000,000 for that building, you’d have a 10% cap rate or a 10% return.
Over the last couple of decades, we’ve seen the cap rates of rental apartment buildings drop from low double digits to the low single digits, as asset prices have climbed dramatically.