Cap Rates In Real Estate Explained
If you’re a real estate investor, you might have heard of the term cap rates. In a nutshell, cap rates are used to compare rent yields between properties. What we find is that calculation of cap rates is actually frequently misunderstood, which leads to it being used incorrectly. In this article, we’ll talk all about cap rates:
What Is A Cap Rate & How It Is Calculated
Cap rate is short for capitalization rate, and it’s used to compare unlevered rent yields between properties. Before you can properly use it, you need to make sure you calculate it the right way.
You get a property’s cap rate by taking your net operating income and dividing it by the market value of your property. Operating income is how much you receive in rents, minus your operating expenses before your monthly mortgage obligations. Operating expenses would include things like utilities, insurance, property tax, condo fees, maintenance and even vacancy allowance.
There’s a few things to note:
First, appreciation is not taken into account and this is important because even though a property has a great cap rate, it doesn’t necessarily mean it makes the best investment. To really find out if you have the best investment opportunity, you should also look into the total returns including appreciation as well.
We also mentioned that cap rate is a metric that compares unlevered returns, so this means it doesn’t take into account mortgage obligations – quite a few investors get this wrong so we really want to stress this. Note that your total returns can look better when you increase your leverage, but this also means that you’re increasing your risk as well.
Next, you need to use the market value of your property when calculating cap rates. If you’re trying to calculate the cap rate on an existing property that you have, you really need to understand the current market to accurate arrive at this number. And this is especially trickier for houses since they all have unique characteristics in terms of things like size, features, condition and parking.
This means you shouldn’t use the purchase price that you got it for years, which really inflates your cap rate and doesn’t make your cap rate an accurate comparison in today’s market. This also means that if you buy a property and renovate it before renting it out, you shouldn’t just use your total cost that you put in. In the same way, using your cost instead of the market value can also artificially inflate cap rates because it doesn’t take into account your own value add efforts. Essentially value add appreciation was left out of the picture, so again their cap rates will be unrealistically higher.
What Makes A Good Cap Rate
Now assuming we calculate cap rates the same way, the next question is: what makes a good cap rate? Here on our Elevate team, we like to invest in real estate with more balanced returns that enables us to scale effectively. This means we choose real estate that offers positive cash flows after your monthly mortgage payments since it’s a more secure investment.
So here’s a quick and dirty trick that we use on our team to check for cash flows. Add 2% to your mortgage rate. This will give you a ballpark cap rate that will give you breakeven cash flows after paying your monthly mortgage payments. If you’re getting a cap rate that is higher than the breakeven cap rate, you’re likely generating positive cash flows, which means a more secure real estate investment that generates better rent yields.
Typical Toronto Cap Rates
Now that you know what makes a good cap rates, let’s go over typical cap rates in Toronto right now (as of December 2020). Because of COVID, rents have dropped around 10% compared to before March. So with adjusted lower rents, typically cap rates for (but can vary more by neighbourhood):
- Toronto condos are at 2-2.5%
- Toronto houses are at 3-3.5%, and
- Toronto commercial properties are 3.5%+.
How To Choose The Best Real Estate Investment
As you can see, cap rates for different types of properties are different. Like we mentioned earlier, many investors look at total returns instead of just cap rates. When market appreciation varies, you’ll likely see varying cap rates as well.
In the case of Toronto condos, some investors were willing to take on very low cap rates even with negative cash flows in exchange for higher appreciation potential compared to freeholds which is pretty speculative. In this case, they had a heavy weight on appreciation. So when appreciation stalls like what’s happening now with Toronto condos, their investment is at greater risk compared to a more balanced real estate investment.
And of course, location definitely matters. Different cities, neighbourhoods with varying gentrification potential can all affect their cap rates so this is something you need to keep in mind. When you get to know investment properties a bit more, you’ll actually find the cap rates and appreciation offset each other. The reason why some cities have great cap rates are to compensate for much lower appreciation potential. So you need to look at total returns to see how good an investment really is.
For example, Calgary may have cap rates that 1% more than Toronto, but appreciation in Calgary is close to 0, so the total returns aren’t actually as good as Toronto freeholds that a good balance of decent cap rates and appreciation. And if two properties have similar total returns, it’s a good idea to choose one that has a better balance of returns from appreciation, rental income, value add potential because there will be lower return concentration risk.
How We Can Help
The key takeaway is that cap rates are useful for comparing investments that have similar characteristics. But if they aren’t very similar, then cap rates shouldn’t be the only metric you use. The best way to compare real estate investments is to look at total returns from appreciation, rental income, value add potential and even loan to value ratios which affects your leverage.
The reason we love Toronto freeholds is that we find they offer a good balance of returns, and this brings the good combination of attractive total returns and reduces return concentration risk. And in this pocket of opportunity in Toronto, they are still not all the same. There is a small subset that can offer higher cap rates, which make the best opportunities in Toronto.
There are limited opportunities like this in Toronto and we specialize in them. If you have a similar mindset and want us to help you secure an investment property that has a good balance of appreciation and positive cash flows, reach out to us and we’d be happy to help.