Capitalization Rates – The Most Misused Metric in Real Estate

Nobody uses cap rates properly. Learn the mistakes even the pros make with this short guide.

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Cap rates can mislead you. High cap rate properties can generate less cash and a lower overall rate of return. Use cap rates when you’re comparing apples to apples. Capitalization rates aren’t sufficient when comparing apples to oranges.

Overview

Real estate investors almost universally misuse capitalization rates. Cap rates are so widely misused that it’s safe to say that you probably misuse it too. Your misuse of cap rates costs you money – a lot of it.

Fortunately, cap rate misuse is easily corrected. By the time you finish this article you’ll know how to use this metric properly.

What Is the Capitalization Rate?

Capitalization rates tells you how much income a property generates relative to its purchase price.

To calculate the cap rate, divide the net operating income (NOI) by the purchase price of the property. The result is a percentage figure, which is the capitalization rate.

NOI/Price = Cap Rate

So what’s net operating income? In broad strokes, NOI is what’s left of the rent you collect after you pay your bills (but before you pay the mortgage).

Let’s work out the cap rate for two fictional properties:

127 Vanier St:
NOI: $20,000
Purchase price: $400,000
$20,000/$400,000 = 5.00%

732 Westboro Ave:
NOI: $30,000
Purchase price: $800,000
$30,000/$800,000 = 3.75%

Easy enough right?

How Am I Misusing Cap Rates?

Misusing cap rates to compare rural and urban properties.

Urban rental properties are more expensive than rural ones. However, the difference in rents is smaller than the difference in prices. As a result, cap rates are higher in rural areas.

Q: Does that mean rural properties are better?
A: No.

Why?

Q: How did urban real estate get more expensive than rural real estate?
A: Urban properties appreciate faster.

Generally, rural properties don’t appreciate when you adjust for inflation. Ottawa’s urban properties appreciate faster than its rural properties do. Over the last 25 years, Ottawa’s urban real estate has appreciated at about twice the rate of inflation.

Additionally,  depending on the lender, financing on rural multifamilies can be more expensive.

Misusing cap rates to compare investments in different neighbourhoods

Cap rates in expensive Westboro are lower than in inexpensive Lowertown. Yet investors still buy income properties in Westboro. 

Why?

A. They want better tenants.
B. They want more appreciation.
C. Both

The answer is C.

Different neighbourhoods present different levels of risk. Investors who buy riskier properties want more reward for that risk. Partly for that reason, cap rates in Lowertown are higher.

Additionally, Westboro has historically appreciated faster than Lowertown, so that adds to the prospective value of real estate investments in Westboro. Cap rates don’t reflect that.

Misusing cap rates to compare different structures

Cap rates on tall apartments are higher than caps on short ones. Tall apartments cost less to build on a per-unit basis. In a tall apartment, some elements can be split among more units. For example, a building needs land. That land costs less on a per unit basis if you build more units on it, which improves the cap rate.

However, structures depreciate; land appreciates. The land:building ratio of garden apartments is higher than the land:building ratio of apartment towers. Consequently, garden apartments appreciate faster than towers do.

Relying on advertised cap rates

Advertised cap rates often assume everything goes right and the owner does the work herself. Vacancy losses, bad debt, management fees, maintenance costs, and professional fees are often omitted. However, not all listings omit all of those expenses. Accordingly, it’s important to ensure you’re doing an apples-to-apples comparison of expenses.

Using cap rates as a substitute for cash flow calculations

Did you know the best time to sell a property is right before the major elements are due for replacement.

Why?

Because everyone over-emphasizes capitalization.

Image of a poorly maintained window
Deferred maintenance is expensive and crushes cash-flow. A healthy cap rate doesn’t guarantee healthy cash flow.

The value of the remaining life of the major elements is often ignored by buyers. To most buyers, a new roof, windows, and boiler is just a perk. But replacing major elements crushes cash-on-cash return, since you can’t finance replacement costs and the cost of replacing major elements can amount to 10% of the cost of the building.

Cap rates don’t consider the financing cost of a property. That cost may depend on the location of the property (urban vs rural) and the number of units (interest is often higher for 5+ unit multi families).

What’s more, if you use cap rates as a proxy for cash flow you’ll ignore the enormous effect of CCA on cash generation (see below).

What Are the Limitations to Cap Rates?

We’ve looked at how cap-rates can be mis-used. So what are the limitations inherent in this metric that make it so easy to misuse?

Cap rates ignore the effect of tax on cash flow

Some new investors forget that they may owe tax on the income their property generates – even if the property doesn’t generate cash. Taxes can eat up all your cash flow. In fact, as a result of taxes, low cap properties can generate more cash than high cap properties.

That’s where the capital cost allowance, or CCA, comes in. On most properties, you can deduct 4% of the value of the structure (not the land) from your rental income for tax purposes.

Consider this fictional example of an old property whose value is mostly in the land:

829 Sandy Hill Dr.

Property value$1,000,00085% land, 15% structure
NOI$35,000 
Cap rate3.5% 
   
Mortgage interest$10,000 
Mortgage principal$20,000 
Before tax cash flow$5,000NOI minus principal & interest
   
Taxes before CCA$17,50050% of NOI
CCA$6,0004% of value of structure
Taxes after CCA$11,500Taxes minus CCA
After tax cash flow:-$6,500 

421 Hintonburg Rd.

Property value$1,000,00050% land, 50% structure
NOI$32,000 
Cap rate3.2% 
   
Mortgage interest$10,000 
Mortgage principal$20,000 
Before tax cash flow$20,000NOI minus principal & interest
   
Taxes before CCA$16,00050% of NOI
CCA$16,0004% of value of structure (max: all rental income)
Taxes after CCA$0Taxes minus CCA
After tax cash flow:$2,000 

So the property with the lower cap rate generated more cash.

Cap rates overlook future performance

This is probably the most common mistake. A property with high turnover (e.g. student housing) will usually have higher average rents over a period, as market rents typically increase faster than rents increased by the maximum amount allowed by the province.

Similarly, a property with tenants paying under-market rent may perform much better when the tenants vacate the property (in fact, you might make their vacating the property a condition of your purchase).

Occasionally a landlord will sign an over-priced lease with a dicey tenant so that she can advertise a higher cap rate for the property. Over-priced leases are rarely sustainable, and it’s likely that the tenant will vacate (often by eviction) and the next tenant will pay rent closer to market rent.

Cap rates ignore appreciation

There’s an inverse correlation between capitalization and the rate of appreciation. Often one is higher when the other is lower. Partly, this correlation is causal: prices are lower when appreciation has been low, which makes higher cap rates easier to attain. The correlation is also a result of demand for total return (income and appreciation): all other things being equal, the expected total return of a property in a quickly appreciating neighbourhood is greater than the expected total return of a property in a slowly appreciating neighbourhood. Consequently, demand for the former property will be greater, which will further accelerate the appreciation of the asset – and by corollary, lower its capitalization rate.

Often the properties with the highest cap rates have the lowest rates of appreciation.

Cap rates overlook risk

Whether we’re looking at stocks or real estate, investors demand more from higher risk assets. As such, investors will demand higher cap rates from properties that are prone to longer vacancies. For example, office and retail space often remains vacant for six months or more. Moreover, in most office buildings and retail strips, a single tenant occupies a greater fraction of the leasable space than a tenant in an apartment tower occupies, so the loss of a commercial tenant typically has a larger effect on the NOI from the property, and consequently, adds to its risk.

When figuring the cap rate of an opportunity, investors will often use a multi-year average vacancy rate to compute the vacancy loss (which reduces NOI). However, if tenants occupy large portions of the property, then vacancy losses will be more volatile than they would be if tenants occupied only a small portion of the property. Protracted vacancy periods further amplify that volatility.

Accordingly, investors should not judge whether they could afford the property based on its capitalization rate (and average vacancy), but on whether they could afford the property if some units were vacant for a period.

Cap rates ignore the value of major elements

New multi-family boiler system in the mechanical room of an income property
If you’re focused on cash-flow positive real estate investments, then you probably don’t want to be the one who pays to install a system like this.

If capitalization is your main focus, then you’re likely a cash-flow focused investor. The replacement of major elements (roof, windows, HVAC, etc.) will claw back months of cash-flow. Investors should consider their planning horizon and the cash outlays required to replace the elements that will need replacement during the relevant period.

Cap rates ignore opportunity costs of uninvested capital

50-dollar-bills-canadian-currency

Suppose you had $2.5M to invest in real estate. You are comparing two properties: Option A costs $2.5M and has a cap rate of 4.5%. Option B costs $2.0M and has a cap rate of 5.0%. Option B has a better cap rate but leaves $500,000 uninvested. If your investment strategy calls for $2.5M of your assets to be invested in real estate, then option B misses the mark in an important way.

Why Do Investors Use Cap Rates?

Cap rates are good for making apples to apples comparisons.

Apples and oranges
Use capitalization to compare similar income properties. Don’t use it to compare apples to oranges.

Cap rates are useful when you’re making quick comparisons of similar investment properties.

For example, if you’re looking at newly built high-end triplexes in Westboro, then you can use cap rates to compare between those investment options.

Where can I find high cap-rate properties in Ottawa?

Look for areas where appreciation is slow

As mentioned above, there’s an inverse correlation between appreciation and capitalization. Properties in fast appreciating neighbourhoods tend to have lower capitalization rates.

Inside the city, properties in Lowertown near Rideau Street have the highest capitalization rates. However appreciation in real (inflation-adjusted) terms has been negative over the last decade (2010-2020). Cap rates on income properties in Vanier are also excellent.

The supply of development land is abundant in rural areas. Consequently, supply can easily meet demand, and so these properties tend to appreciate more slowly. So it’s no surprise that we see exceptionally high capitalization rates just outside of the city, where zoning does not impede development and most land is available for development. As a high-cap rate opportunity, Limoges stands out among the towns outside of Ottawa.

Look for areas where perceived risk is high

Investors looking for high cap-rate urban properties with strong appreciation may find opportunities in gentrifying neighbourhoods that are still perceived to be higher risk. Cap rates on income properties in Vanier, Overbrook, and the far east of Carlington.

Contract an expert who knows Ottawa investments

There are a handful of realtors in Ottawa who specialize in investment properties (John Castle). Interview a few until you find one with demonstrable expertise, integrity, and a strong work ethic.

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