Capitalization rates, or cap rates, are a way of estimating the general rate of return of an apartment building by buyers or sellers.

The cap rate for an apartment transaction is calculated by dividing a building’s net operating income or NOI into the total value of the transaction or sale (Value = NOI/Cap Rate).  

This is the calculation made by brokers and industry observers for each transaction and these people often provide their clients and customers — building owners, buyers, investors, and lenders — with a summary of typical cap rates by product type, or publish cap rate ranges in quarterly reports and newsletters.

For example, a major Canadian real estate firm recently released its Q4 cap rate summary report for 2015 which lists cap rate ranges for A- and B- grade apartments in Canada’s major cities.

These cap rate ranges stretch from a low of 3.25 per cent (in Toronto) to a high of 5.5% (in London and Windsor) for A-grade apartments, and from 4.25% (in Toronto and Vancouver) up to 6.25% (in London and Windsor) for B-grade apartments.

Cap rates, spreads very complex

Although it is tempting for building owners to take these cap rates and apply them to their own buildings, in reality cap rates and cap rate spreads are very complex and need to be understood within the context of product availability, quality, and investor demand.

Apartment building owners want to know the value of their buildings to help them decide if it is time to sell, especially in market conditions in which demand for investment properties exceeds the supply of listings.

An unsophisticated seller may take their NOI and divide it by an expected (or hopeful) cap rate, arriving at a potential total value.

What most owners don’t realize is this approach is unreliable because the cap rates they use are often not the right ones; using an industry average cap rate, or worse, another transaction’s cap rate, can yield the wrong value and expectations, often to the detriment of the potential seller.

Cap rates vary greatly from market to market, for new versus old buildings, by quality level, and fluctuate over time based on economic conditions (ex: a flood of foreign investors to the stable Canadian market).

Can’t make assumptions

Therefore, it is unwise to assume because an apartment building sold at a five per cent cap rate in Toronto a similar building would also sell at a at a five per cent cap rate in London or Ottawa, for example.

Cap rates vary based on the following factors: (1) product availability, (2) product quality, and (3) interest by foreign investors.

Of these factors, the impact of the first two should be self-evident to anyone in the apartment industry and can be quickly explained by saying an apartment building in Sudbury or Sault Ste. Marie will have a different cap rate than a similar building in Toronto, and an A-grade building will have a different cap rate than a B-grade building.  

The third factor — interest by foreign investors — requires some explanation.

In the course of our business as brokers, we have observed an interesting trend which has significant impacts on cap rates and pricing in the apartment industry: currently, large numbers of foreign investors are paying high prices to obtain apartment buildings in Canada, prices above and beyond what we would have expected building to attract under normal circumstances.

These investors are seeking to park and protect their money in an increasingly volatile world and they have little or no interest in cap rates, only in gaining access to the Canadian real estate market. These investors are distorting the cap rate picture across the country, especially in major markets and/or for top-quality assets.

No reflection of values in broader market

Building owners, brokers, and industry observers should not interpret the low cap rates paid by these investors as a reflection of apartment building values in the broader market, or an indication of expected cap rates for other transactions.

It is too easy for apartment building owners in secondary and tertiary markets, or with B- and C-grade buildings, to see these low cap rates, look at their own NOI, and derive unrealistic valuations for their buildings based on cap rate equation, when in most cases they should be using much different cap rates.

The good news is the opposite can also be true, and our firm is currently working with more than a handful of high-net-worth private investors who are looking to place capital into high-quality assets.

What can building owners do to make sure they’re using the right cap rates and valuing their buildings accurately?

It is important the broker whom apartment building owners hire to sell their buildings not only knows selling, but also knows the subtleties of the market and, more importantly, its active buyers, and can translate this knowledge into the right sales package and presentation.

Here at SVN Rock Advisors Inc., we take market knowledge very seriously and work hard to ensure we know the market and its players so we can provide the best service to our clients and get them the best prices for their buildings.

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Derek Lobo is the founder and CEO of SVN Rock Advisors Inc., a real estate brokerage with over 30 years of experience in helping investors make the most out of buying, selling, and renovating purpose-built apartment buildings. Learn more about SVN Rock Advisors Inc., Brokerage on their website at www.SVNRock.ca.