If you’ve looked into or read about real estate investing, you will have seen the term “capitalization rate” or “cap rate” being widely used as a measure of investment performance. But what exactly IS a cap rate?
That question has baffled many an investor, even professional realtors. Yet the answer seems easy. The capitalization rate is the rate of return on investment – generally of an industrial, commercial or multi-unit residential property (ICI).
It is calculated as follows:
Cap rate = (net operating income / market value) x 100
So if the net income is $50,000 and the market value is 1 million (50,000/1,000,000) x 100 = Cap rate is 5%
Easy, right? Well, yes and no. The problem is, how do you work out the true net operating income and how do you establish market value?
Net Operating Income (NOI)
The NOI is the most widely used indicator of a building's financial performance. The NOI is the cash remaining after deducting the operating expenses from the gross income.
NOTE: There are several items, which often appear on financial statements, which must be deleted before calculating the NOI.
- Debt service, such as principal and interest payments, are ignored because the NOI reflects the earning capacity of the property exclusive of financing.
- Depreciation allowances or any other purely bookkeeping or income tax deductions are ignored.
- Capital expenditures that provide long-term benefits, such as replacing appliances, painting of the building, etc., are also omitted.
Now this is often overlooked – particularly No. 3 – but think about how important that is. You, the investor, may think that you are getting that fine 5 per cent return, but by the time you allow for necessary capital expenditures you may well be down to 4 per cent or less. Particularly of you are buying an 80-year-old building.
The other issue on establishing the true NOI is the possibility that the owner is talking “projected income” and not actual income. In fact, often the statement is only the best possible hope of the owner and not reality.
Like a regular appraisal on a house, an appraiser needs to find comparable sales that recently took place of similar properties in order to make a value assessment. But there is a catch…
ICI properties do not sell as often as houses and comparable sales may be hard to find. Information relating to a sale of a commercial property is often confidential and difficult to obtain. While the sale price can usually be determined, the income and expense statement, net operating income, etc., is often not available, making it difficult to calculate the financial measures for comparing purposes.
You also need to try to understand the underlying motives behind the purchase and adjustments that may have been made by the purchasers, or the results of the negotiations between the buyer and the seller, as well as economic conditions, etc. The questions is: Was it an arm’s-length transaction?
In some instances, the purchaser/seller may be strongly motivated by income tax considerations. Other times; the motivation may be to move money into another country by an overseas investor. As we know, this is happening now here in Vancouver – many overseas buyers simply want to park money in a safe country and are less concerned about returns, more about safety.
If you are unaware of special buying or selling motives, or that the purchaser has made adjustments to the price because of special circumstances, such as the requirement for major repairs or because of favorable or unfavorable existing financing, then the calculation of the financial measures will be incorrect.
Thus, on the surface, the calculation of cap rates seems to be a relatively simple process. However, it is fraught with difficulty and uncertainty, and requires a lot of digging for information, questioning and being alert to special circumstances, which may distort the answers.
As an investor, always:
- see actual financial statements for two years minimum;
- make sure the debt services, depreciation and capital expenditures are not included in the calculation;
- ask question to make sure there were no special circumstances in the deal;
- realize that the cap rate is applied to an 80-year-old building and a five-year-old building equally, so you must consider other factors than just income;
- assess the quality and staying power of tenants;
- know the length of the leases and their expiry dates;
- find out about tenant inducements – what was paid to tenants that they will not pay for at lease renewal; and
- understand the general leasing market conditions.
Often in my purchasing of income-producing properties, I have found great value in knowing the cap rate of a city rather than the individual building. If Miami has a cap rate of 5 per cent, Vancouver’s clocks in at 4 per cent but Phoenix has a rate of 10 per cent, I get an idea of where I want to own that income cash flow.