What is a Cap Rate?
When it comes to real estate buying and selling, terms such as cap rate and return on investment (ROI) tend to dominate the conversation. So, what is a cap rate?
Also referred to as capitalization rate, a cap rate is a way for buyers and sellers to estimate what the potential rate of return of an apartment would be.
One aspect that is commonly used to understand or help determine the value of an apartment in the market is the cap rate. This is done by simply dividing the building’s net operating income (NOI) by the total value of the sale.
In Toronto, the average apartment building cap rate is usually below five percent and most would place it around the fourth percentile.
To help illustrate this point further, we take a glimpse at a quick example:
If you invest in a real estate property that costs you $1 million and end up generating $70,000 per year of net operating income (NOI), then that property will have a 7% cap rate.
Interpreting cap rates is fairly simple. A higher cap rate implies high risk while a low cap rate is an indicator of low investment risk. This is the reason why cap rate is such a key factor when it comes to real estate investment in Toronto.
The Complexity of Cap Rates
Although the capitalization rate should be easy to interpret, it can also get complex depending on the scenarios and context. Luckily, industry observers and brokers are often responsible for sharing cap rate information with customers, building owners, buyers, investors, and lenders.
When industry observers share cap rates, they are summarized according to product type and location. It’s important to note that cap rates may vary from time to time depending on market factors.
To have a better understanding, let’s look at some of the factors you should pay attention to while analyzing cap rate.
Factors to Consider When Analyzing Cap Rate
Determining the ideal cap rate is dependent on the property class you are looking into among other factors listed below.
Property class can also be referred to as asset class. It could be a hotel, office, retail, multi-family, just to name but a few.
Among these property classes, multi-family seems to have the lowest cap rate. The market reality that has always been constant for the most part is that people will always be looking and needing a place to reside in irrespective of economic factors.
That also means that it has the least level of real estate investment risk, a feature that makes this asset class a sure winner.
The debate on what is a good cap rate for multi-family never seems to end. But the reality is the average cap rate for rental property can change from time to time as a result of fluctuating interest rates, old vs new buildings, and in some cases, economic conditions such as an influx of foreign investors and migrants such as is the case with Toronto. Enlisting the help of an investment consultant in knowing what the ideal cap rate is at any given time is a great way to go about this.
Nevertheless, with a lower cap rate, you as an owner would be advantaged as it means you can sell higher because of demand.
There is an ever-raging debate as to whether the cap rate is the sole determining factor of buying or selling a piece of real estate. If you are buying, long before you even get to the cap rate, you will want to look at what is known as the ‘debt coverage ratio’.
In Toronto, the ratio should be at 1.25, meaning that your net operating income (NOI) is 25% higher at a minimum than your debt. If your NOI is at 50% more than your debt; i.e., 1.50, that is even better. In essence, the debt coverage ratio is a far more important aspect in purchasing than the cap rate.
Location is an inevitable factor and a top consideration for buyers and sellers alike. Location is what drives demand and, therefore, cannot be ignored.
Similar properties in a metropolitan area such as Toronto may have significantly different cap rates just based on their location. Properties closer to downtown Toronto will tend to have a lower cap rate as well as low investment risk in comparison to properties in the suburbs.
Although this happens to be the common trend, every locale will have perceived risks depending on the buyer’s need and objectives.
Fluctuating interest rates might be out of your hands, but when they do occur, they can have a negative impact on the cap rate and, hence, the value of your property. It is for this reason that you would want to know in which direction interest rates are likely to blow just so that you may prepare accordingly.
When interest rates rise, it translates to a subsequent rise in the cost of debt, which in turn, decreases NOI. This information can be vital to both buyers and sellers in taking advantage of market factors.
Generally, home sales seem to have declined in Toronto in light of the high cost of buying a home with the present market conditions. At the same time, the demand for rentals has spiked, making it profitable for those with multi-residential assets.
Naturally, homeowners are unwilling to sell at this point as the market favors them. This trend is unlikely to change any time soon if market factors remain the same.
If you are an investor or aspiring to be one, this a good time to cash in on the available opportunities. With the help of an investment consultant, you can learn of more opportunities available in the market and be able to make the right decision.