Featured Post, Local Kitchener Waterloo, Real Estate Investment

On Cap Rates and Capital Growth

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 ?

–

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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