Dr. Landlord: The misunderstood cap (capitalization) rate

By Chris Seepe

“Landlording” author and instructor Chris Seepe is teaming with REM to publish a series of articles covering a broad spectrum of residential rental landlording topics that may not be common knowledge to the average landlord.

Cap rate (CR) is arguably the most often quoted metric for expressing property value. Yet, it tells only half the story.

Why is there such emphasis on CR? Because it allows you to financially compare two widely differing rental properties. A poorly managed nine-plex could be less profitable than a well-managed six-plex.

CR expresses the relationship between a property’s current year’s net income and the property’s value. It helps but doesn’t completely determine the value of an investment property and its potential return on and of an investment.

CR is calculated by subtracting all operational expenses (excluding financing and capital expenses), plus vacancy and bad debt from the property’s total income and dividing the result – called net operating income (NOI) – by the current value or sale price of a property. It’s expressed as a percentage. There’s a mathematical inverse relationship between property value and CR: the higher the CR, the lower the property value and vice versa. Buyers want a high CR. Sellers want to offer a low CR. The buyer’s higher rate of return is reflected by the seller’s lower sale price.

Listings may cite CR but often exclude or include expenses that a lender doesn’t care about or that are not actually an operating expense. The most common “missing” expenses are repairs and maintenance, property management and vacancy and bad debt. Excluding these expenses make a CR look much better than it is. Because of that, lenders add in missing expense approximations, which then drive property value down. This in turn reduces the mortgage amount and the deal “fails because of financing”.

For example, a property generates $100,000 in annual gross income. The listing states total operating costs are $35,000, generating $65,000 NOI. Divide NOI by five per cent CR = $1,300,000 baseline property value. You expect to receive 75 per cent of the value as a mortgage, called loan-to-value (LTV) = $975,000.

However, the listing didn’t include vacancy/bad debt (typically two to four per cent), repairs/maintenance (typically $750 to $800/unit) and property management (average five per cent). The property’s expenses are actually $45,000, generating $55,000 NOI, divided by five per cent CR = $1,100,000. Therefore, the lender’s $10,000 in added expenses reduced the property’s value by $200,000. Seventy-five per cent LTV = $825,000 mortgage, which is $150,000 less than you expected. Unless you can come up with that difference, the deal fails.

CR can provide solid insights into a property’s financial performance, but because CR is based on NOI, it doesn’t factor in financing and closing costs so it won’t tell you how much profit (cash flow) you’ll make.  It doesn’t consider a property’s state of repair, so you may have to invest extra money into major capital expenses such as windows or a boiler. It doesn’t project appreciation or geographic growth potential or consider local crime rate and types; tenant demographics; the quality, construction, size and age of a property; or the property’s proximity to amenities. CR doesn’t forecast increases in operating and financing costs, possible right-of-way issues or environmental concerns.

When a buyer declares in a “5.0 cap” market that they will only look at properties with a 6.0 cap, they’re saying they want a property with a high NOI at a deeply discounted purchase price. Well, shucks and golly gee, don’t we all want that? Such buyers are looking for bargain-basement investment properties they’re unlikely to find and they’ll never make a purchase.

A property’s market value generally assumes it’s in a good state of repair, the land is employed for its “highest and best use,” and its rental revenue reflects all the local positive and negative market influences. The market assumption is that the buyer won’t have to lay out any immediate cash for capital costs.

No seller should expect to receive market value for their property if any of the above isn’t true. To expect otherwise, the seller is saying they want you to pay for the property’s future potential even though the seller did nothing to deserve a share in that future potential. If a seller wants to benefit from that potential, they should invest the time and money to first realize that potential and then sell their property.

A seller might purposely offer a higher CR if the property is “stigmatized” and requires a buyer who doesn’t care about the stigmatism, or it may be “distressed”, requiring a notable influx of cash to fix the problem.

The next article in this series will discuss how the marketplace and individual buyers and sellers determine what the CR should be.

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