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The limitations of cap rates in real estate transactions

Property buyers and sellers have traditionally turned to the capitalization rate formula to deter...

Property buyers and sellers have traditionally turned to the capitalization rate formula to determine if a property is a good investment. The problem is that a cap rate alone does not give you the full picture.

Many people are familiar with cap rates, but let’s summarize. A cap rate is a formula calculating the rate of return of a commercial real estate property. A low cap rate is typically good for a seller because it means your property’s value is higher. A high cap rate is good for a buyer because it means you should pay less for the property.

The formula is simple: Net Operating Income (NOI) divided by the property price (Cap Rate = NOI ÷ Property Price).

Sometimes what you see isn’t what you get. The simple cap rate formula doesn’t consider many other key factors that determine whether to go ahead with an investment.

What you should consider

Cap rates, for example, don’t always take into consideration potential:

– under market rents;

– capital investments required;

– capital investments made;

– favourable/unfavourable debt;

– rising or declining rental market; and

– renovated or unrenovated units.

Here, we show you a high-level example using a few of these factors in the overall equation. Example:

Both Building A and Building B are selling for $10 million. Building A produces $500,000 in NOI. Building B produces $425,000 in NOI.

Building A: $500,000/$10,000,000 = 5 per cent cap rate

Building B: $425,000/$10,000,000 = 4.25 per cent cap rate

Building A appears to be the better investment.

If we look a little deeper, we realize that both buildings require repairs and that the rent is below market and needs adjusting. By adding more of these key factors to the equation, you get the intrinsic capitalization rate, a more accurate reflection of your investment’s return rate potential.

Building A: $550,000/$11,400,000 = 4.8 per cent cap rate

Building B: $515,000/$10,100,000 = 5.1 per cent cap rate

You can see now that Building B is a better investment.

Cap rates vary by city and asset class

Cap rates vary based on the asset class and the location of the property.

A retail plaza in downtown Toronto, close to high-rise condos and a transit node, will demand a lower cap rate than a large plaza located in a town with a population of 1,000.

Cap rates for a particular asset are a broad indicator of current market fundamentals and future potential. A low cap rate also shows a buyer’s confidence in the market and their ability to reposition the property to make it profitable in the future.

Recently, cap rates have been compressed, mainly due to lower interest rates, which will continue into 2021. These compressed rates create a perfect environment where sellers make large profits and buyers who are in tune with the market capitalize on a property’s hidden potential.

There is a cost to these hidden potentials in buildings, like renovations and other capital improvements.

That’s why a buyer who doesn’t rely on cap rates alone to evaluate an investment will look at the long-term profitability when determining what price to offer.

To learn more about cap rates or any other topic related to building wealth through private real estate investing, visit the Equiton website.

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