January 2008

On Cap Rates and Capital Growth

January 29, 2008 by Benjamin Bach · 2 Comments

Last week, a prospective investor from Stratford, Ontario – a picturesque town about 30 minutes from Kitchener Waterloo – emailed a question to me.

She asks, "What is, and how do you calculate a Cap Rate ?"

Great Question. Cap Rate, short for Capitalization Rate, is a rule of thumb (a rough calculation) that compares the net income of a property relative to the market value.

Net Income means the income left after paying the operating expenses and taxes on a property – it usually will not include servicing the debt – or the mortgage payments.

A property listed for $1,000,000 with $80,000 in net rental income (so, this might be $120,000 in gross rental income, and 40K in expenses like management, property taxes, utilities, hydro, maintenance, vacancy allowance, reserve fund contributions etc.) would have a cap rate of 1,000,000 / 80,000 – or 8%.

After I answered her question, I cautioned her against relying on the cap rate to evaluate a solid investment property. It seems conventional wisdom still says that a high cap rate is the golden turkey of Real Estate Investing.

I like disputing conventional wisdom, so I told her:

Cap rate doesn’t take into account financing options, location, condition, vacancy, zoning, permitted uses, property type etc., so it’s not usually a precise analysis relied upon by investors and real estate investment professionals.

A high cap rate is preferable every time…. as long as the property is in great shape, well located, attracts good tenants, and will let your capital appreciate at a healthy, and optimized rate. Now… if you’re chasing a 11% cap rate, and buy a property in need of some work, in the area of town that isn’t the greatest… it could cost you a fortune over the long run.

The cap rate doesn’t consider the age of the house, the condition, the location, the vacancy rate of the area, the potential future use of the home, the prospects for appreciation of your capital (i.e. what really matters).

An investment property with a 7% cap rate in great shape, in an in-demand neighbourhood with solid prospects for appreciation and growth, is preferable (to me and most of my clients) to rental home with a 11% cap rate in need of work, in a sub-great area of town. Does this make sense to you ?

As Jeff Brown said this week:

If growth is your primary goal, acquiring double digit cap rate properties will almost always have the following two consequences:

1. Your cash flow will increase, relative to your last property.

2. Your capital growth rate will simultaneously decrease, as most smallish residential income properties sporting high cap rates are in lower demand areas.

THAT’S WHY THEIR CAP RATES ARE SO DARN HIGH. [emphasis mine]

Don’t chase cap rates; find opportunities for your capital to grow at an accelerated rate. That way, when you decide to stop working at your job you are wealthy enough to do whatever you want.

That’s why most of us are investing in real estate in the first place, right ?

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Benjamin Bach Cartoon

Kitchener Waterloo’s Favourite Real Estate Agent* wants to show you how Real Estate Investing can make you wealthy. Benjamin works with people from across Ontario and Canada helping them build wealth through smart real estate investments.

Benjamin is a Sales Representative with Keller Williams Golden Triangle Realty in Kitchener Waterloo and would love to answer any questions about buying or selling a rental, income or investment property.

You can reach Benjamin at Benjamin(AT)BenjaminBach.com or call him at 519 570 4447

*Gold Award, Kitchener Waterloo Record Readers Select Awards 2007 – 2008

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Would you rather have 1 condo in Kitchener Waterloo or 2 ?

January 21, 2008 by Benjamin Bach · 2 Comments

That’s the question I found myself asking after completing a quick analysis I did for a client looking to invest some equity in the Kitchener Waterloo Real Estate market.

With an initial $30,000 to invest, coming from non-performing equity ("dead money") in their principal residence, we have a few options. Naturally, we want to pick the option that maximizes return while minimizing capital risk (i.e. we want to make money while preserving the capital we’ve investing)

My client wanted to know what effect different down payment amounts would have on the growth of his family’s equity. Should he put more down, or less?

Good question!

I explored two scenarios for what real estate property he could acquire with that initial investment:

Scenario 1 had the client acquire 2 condominiums in Kitchener Waterloo for around $130,000 each, with a 10% downpayment. Accounting for closing costs, we’re going to say the initial investment in each condominium is $15,000, which lets us acquire two units with the initial $30,000 equity.

Scenario 2 has the client use the same $30,000 to acquire 1 condominium in Kitchener Waterloo, with a more traditional 20% downpayment – $26,000 + closing costs.

Scenario 1: $260,000 in property. Scenario 2: $130,000 in property

In Scenario 1, you’re looking at between $20-50 a month negative pre tax cash flow per unit; Scenario 2 yields about $50 a month positive pre tax cash flow, after accounting for condo fees, tax, and mortgage payments (which are a bit higher in Scenario 1 since you’re borrowing more, and are likely incurring mortgage insurance premiums).

In the grand scheme of this client’s family income & tax considerations, $50 either way doesn’t make a big difference each month.

Fast forward a couple of years. Say the value for these condominiums have risen 10%, not an unreasonable assumption given the past performance, and prospects for growth in the Kitchener Waterloo real estate market. What do the two scenarios look like?

Scenario 1: 2 condominium units, each worth $143,000 ($130,000 initial price plus 10% appreciation, or $13,000)

$23,600 returned on initial $30,000 investment, for a 79% ROI

Scenario 2: 1 investment condo worth $143,000

$14,200 returned on initial $30,000 investment, for a 47% total ROI

Even after accounting for the positive cash flow from Scenario 2, and the negative cash flow from Scenario 1, Scenario 1 - acquiring the condominiums with 10% down to maximize the growth of capital – yields a significantly higher ROI – return on investment.

My client can acquire twice as much real estate investment property with the same amount of equity, and significantly increase his capital growth rate.

Most people don’t realize how much money they’re leaving on the table by not ‘optimizing’ the growth rate of their equity. Many people just don’t know what they don’t know. By educating yourself before you acquire your first investment property, or before you buy your next rental home, you will dramatically increase your returns and the rate at which you build your family’s wealth.

Don’t be like most people – be like my client: have your equity working hard for you.

Sign up now for my FREE Millionaire Real Estate Investment workshop, February 7th @ 7pm and learn proven strategies and models to acquire a Millionaire’s real estate investment portfolio.

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Benjamin Bach Cartoon

You can reach Benjamin at Benjamin(AT)BenjaminBach.com or call him at 519 570 4447

*Gold Award, Kitchener Waterloo Record Readers Select Awards 2007 – 2008

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