There are a few key ways to measure the profitability and ROI potential of a real estate investment. Capitalization rate (cap rate) is the most popular way amongst real estate investors. It’s a simple formula that assigns a percentage to an investment property, so that it can then be compared to similar investment opportunities in the market.
Cap rate is a useful tool for real estate investors. Today’s post will explain how to calculate cap rate, why it matters when investing in real estate, and why smaller markets with higher cap rates could end up being the best long-term investment in your portfolio.
Cap rate 101: key takeaways
- To calculate the cap rate of a commercial property, determine the market value of the property, determine net annual operating income, and divide the market valuation by the NOI. Multiply this figure by 100 to get your cap rate in percentage form.
- One of the main things cap rate indicates is how long it will take to recover your initial investment. If you invest in a property with a cap rate of 8 percent, it will take around eight years to recover your initial investment.
- Cap rate tends to correspond with risk. In general, properties with low cap rates are considered low risk, indicating strong market demand at the time the cap rate is calculated. Meanwhile, properties with high cap rates are considered high risk, indicating lesser market demand at the time the cap rate is calculated.
- Cap rates are subject to market fluctuations. When investing in property, it is important to not only consider cap rate (which will tell you about the profitability of the investment based on current market conditions), but the fundamentals that might affect the future health of the market.
- Cap rate should be used as just one tool in an investor’s toolbox. Cap rate can be used in conjunction with the per unit price, which can be ascertained from evaluating the market fundamentals.
- Sudbury, Sault Ste. Marie, and Moncton are small markets, but they boast promising, up-and-coming economies, job markets, and real estate markets. Real estate in these cities can be acquired at a lower purchase price and tend to have lower operating costs (indicated by the higher cap rate) meaning more cashflow and cash in your pocket immediately.
Understanding capitalization rate
Cap rate is a metric frequently used by real estate investors to ascertain the rate of return on an investment property. More broadly, cap rate can be used to determine the value of an entire property class or market. Here’s how to calculate the cap rate of a commercial property.
Step 1: Determine net annual operating income or NOI. NOI represents the day-to-day revenue and profitability of a commercial property. To calculate NOI, determine all income produced from the property (such as rent, parking, and laundry, etc.), and subtract any necessary operating expenses. Operating expenses include things like property management, owner association dues, taxes, and insurance. Mortgage payments and any financing should not be factored in.
Step 2: Determine the current market value of the property. You can do this a few different ways. For instance, you can do a comparative market analysis or use an online valuation tool. That said, valuing real estate can be difficult because every property has unique features, such as location, lot size, floor plan, and amenities, which must be factored into the valuation. General real estate market conditions, like supply and demand, will also play into valuation. For a commercial property, such as a multi-family apartment building, you should consider hiring a professional appraiser to ensure you’re getting the most accurate valuation possible.
Step 3: The final step is to divide the figure from Step 1 (the net annual operating income) by the figure from Step 2 (the current market value of the asset). Multiply this figure by 100 to get your cap rate in percentage form.
Using cap rate as an investment tool
Once you understand cap rate on a technical level, you can begin to use it as a metric to help you suss out sustainable investment opportunities and make confidant choices as an investor. For investors to effectively utilize cap rate as a tool, there are two main things to understand and consider.
Cap rates indicate a rough timeline for a full return on investment
So, for example, if you invest in a property with a cap rate of 8 percent, it will take approximately eight years to recover your initial investment. By that logic, if you’re interested in a shorter-term investment, where you will see ROI fairly quickly, your best bet is to invest in property with a lower cap rate. Conversely, properties with a high cap rate may not yield ROI quite as quickly, but they may outperform in the long-term, on a risk-adjusted basis.
Cap rates are correlated to risk and are subject to market fluctuations
Whereas a property with a low cap rate may be less risky in the interim, cap rates are always subject to market fluctuations. A good example of this is properties in the City of Toronto. Let’s consider multi-family properties in Toronto, which had an average cap rate somewhere in the arena of 3 to 5 percent prior to the pandemic. While investors may have seen promising ROI in years past, real estate in Toronto was hit the hardest by the economic downturn ensued by COVID-19. This will cause cap rates in Toronto to go up.
Meanwhile, properties with higher cap rates correspond with a higher level of risk, indicating low market demand and an relatively untested market at the time the cap rate is calculated. That said, they can be acquired at a lower purchase price and tend to have lower operating costs, meaning more cashflow and cash in your pocket immediately. They can also be less volatile in the long-term.
Though there is much dispute over what qualifies as a good cap or a bad cap rate, it entirely depends on the context of the property and the market—both presently and in the future. For this reason, cap rate should be used as just one tool in an investor’s toolbox, in that it can be incorporated into the overall assessment of a property or unit’s value.
Making a high cap rate work for you
As we mentioned earlier, cap rates are subject to changes in the market, good and bad. The same logic that indicates that Toronto’s cap rate will rise due to changes in the market can be used to predict the trajectory of cap rates in up-and-coming Ontario submarkets, such as Sudbury, Sault Ste. Marie, and Moncton.
Let’s start with Sudbury. In Sudbury, the average cap rate for multi-family properties in the city is 8 percent, which is high compared to Toronto’s cap rate. Sudbury’s cap rate indicates that the cost to acquire property in Sudbury is significantly lower than it is in Toronto. Now, if you study Sudbury’s market, you’ll see that the population is growing and the economy is expanding. In part, this owes to the city’s bourgeoning mining industry, which has a big part to play in the global commodity and electric vehicle boom. As such, thousands of jobs will be added to the market in the coming years, contributing to an existing rental supply shortage in the city that’s driving vacancy rates downwards.
Similar to Sudbury, Sault Ste. Marie‘s economy and real estate market will be positively impacted by the commodity and electric vehicle boom. So, though Sault Ste. Marie’s cap rate is between 7 and 10 percent, depending on the area, it will likely drop, as market demand in the region grows on par with economic development and job creation. Building costs in Sudbury and Sault Ste. Marie are also significantly lower than in bigger markets, which bodes well for cap rates of new builds.
Finally, Moncton is garnering repute for being one of the best long-term investment cities in Canada, due to its affordability and livability. Its economy and population are outpacing every other city in New Brunswick, which has contributed to a record low vacancy rate of 2.2 percent. Real estate demand is on track to stay strong in the coming years, thanks to job creation fuelled by institutional development projects, record construction activity, and large companies, such as TD Insurance, expanding operations in the city. Cap rates in Moncton for multi-family apartments are around 5 to 6 percent, with the average being closer to 6 percent.
The bottom line is that while it’s important to consider the cap rate of a property or potential investment opportunity, there are many other factors at play that speak to not only the strength of the investment at that time, but to its future strength. As we’re observing in smaller markets like Sudbury, Sault Ste. Marie, and Moncton, real estate investments in these cities are bolstered by (a) approachable cost of acquisition, (c) lower operating costs, and (c) real proof of future market demand. Therefore, if you manage to snag a property in a smaller market that shows strong market fundamentals, your ROI potential is poised to be strong and steady.