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The Caswell Team

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What the heck is a Cap Rate?

(Published on - 5/26/2019 4:42:27 PM)

For this blog entry, I’m continuing the conversation about the Rental Income/Multi-Family sector in Sudbury while putting more focus on the formula side of things.

Rental income is high due to low vacancy rates in Greater Sudbury, therefore providing above average returns on investments.  Though rents are high, purchase prices remain steady and, in most cases, buyers can purchase a Rental Income Multi Family property, finance it and still have a positive cash flow - you just have to know how to calculate it!

But before I get too deep into it, if you’re considering entering into the world of investment properties, as I mentioned in my previous Multi-Family blog entry, I highly recommend partnering with a Realtor® that has very good understanding of rental income properties and all of the important factors that are involved in this type of transaction.

So how do we know what is a good price to pay for one of these types of properties?

Today, I am going to talk about Capitalization Rate (also known as "Cap Rate"), which is a financial formula that provides a net operating return percentage before financing.  When a seller lists a property on the MLS™ system, you should see the Gross Income (annual total rental income) and Expenses (combined annual property taxes, insurance, utilities,etc.).  The Net Operating Income (often referred to as “NOI”) is Gross Income minus Expenses.  To determine the Capitalization Rate, you take the Net Operating Income divided by the purchase price to get a percentage result.  This formula is what you see in the picture above!

Here's an easier look at these:

Net Operating Income (NOI) = Gross Income - Expenses

Capitalization Rate (Cap Rate or CR) = NOI ÷ Purchase Price (value)

As an example, if you have a building with an NOI of $51,000 and the purchase price is $625,000, the Cap Rate would be 8.16% ($51,000 ÷ $625,000 = 8.16%).  This basically says that, if you paid cash for this property, you would realize an 8.16% return annually on your investment (also known as “ROI”).  This along with building appreciation and future rent increases provide an investor a good return.

Whenever I see a new listing, I always do a quick calculation to determine the Capitalization Rate to see if the financials are in line with the Sudbury market.  You will see ranges from 4%-12%, with the average normally being in the 7%-9% range.  I often receive calls from Buyers that are quickly drawn to the higher returns (who doesn’t want a 12% ROI!), but I talk them through the fact that higher returns can often come with higher risk.  Some of these risks can be one, or an accumulation of, location, tenants and building structure.

As examples, the purchase price of properties in less desirable areas of Greater Sudbury are lower, thus resulting in a higher Cap Rate.  But, remember, when it comes time to sell, your buyer market is reduced as some buyers just aren’t interested in investing in areas where it is in a downward cycle or viewed as "less desirable".  Tenants can also a big factor in the equation as there are good and bad tenants and the latter will add stress and potentially devalue a building due to the lack of care they provide to a property.  Finally, a poor building structure may have a purchase price lower than market value but do you need to add in the cost of new windows, shingles, heating system, foundation repairs, cast iron plumbing replacement or any other large capital expenses that can come up after completion?

The Capitalization Rate is helpful as a starting point for a quick snapshot of a properties financial potential but shouldn't be the only factor in determining whether the property is the right investment.  Some experienced buyers typically have their own financial analysis that they rely on and will add several more factors to the Cap Rate calculation that will reduce the return percentage.  Some of these expenses may be Vacancy Rate percentages, Reserve Funds set aside for future requirements, Property Management, Maintenance and Repair, and Snow/Garbage Removal.  All of these are legitimate expenses but, to compare apples to apples in MLS™ listings, for the most part, these expenses are rarely listed and every owner is going to approach ownership in a different way – more hands-on versus outsourcing day-to-day operations, for example.

A buyer’s risk tolerance will best determine the right property for the buyer.  The key being purchasing a property that balances risk with financial performance and that is where partnering with an experienced Realtor® is to your absolute advantage and benefit.

Whether you’re a seasoned veteran in the world of income property ownership or If you’re thinking about taking that first step into investing but not sure how to get started, my teammates and I have a ton of experience in Multi-Family, Investment and Commercial real estate.  You can always start by clicking here to check out all the income property listings in Greater Sudbury on our www.SudburyRentalProperty.com website that is updated daily and try out the formulas we just discussed!  Never be shy to reach out to us to discuss your vision and goals with us and we can start to build, or enhance, your real estate investment portfolio.  It’s never too late to start!

Contributed by:

Gary Doyle

Cell - 705.691.6166

gdoyle@realtyexecutives.com

 

Disclaimer: The views and opinions expressed in this article are solely those of the author(s) and do not necessarily reflect the official policy or position of any other salespersons, staff or affiliates of Realty Executives of Sudbury LTD. Brokerage, Realty Executives International, the Sudbury Real Estate Board, Ontario Real Estate Association, Canadian Real Estate Association or any of their subsidiaries.  For any concerns pertaining to the content herein, please contact us immediately at caswellteam@realtyexecutives.com.

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