Real estate investors often think that cap rates alone are the greatest determinant of a prospective property’s value, but that isn’t the case.
“I think, to a certain extent, it’s an important number to know. But I don’t think it should be the only number informing an investor’s decision to buy something. There’s a lot more to it than just knowing the capitalization rate because there could be a lot of variations,” Cliff Fraser, chief business development officer of Burlington, Ontario-based Equiton Inc., said of cap rates, which are calculated by taking the net operating income (NOI) and dividing it by the building’s value.
“It’s important to know the cap rate of a property, but it’s also critical to understand it may be different than the ‘average’ cap rate of the area and examine the nuances of a particular building that you are considering. For example, a property in Toronto may be more desirable depending on how close it is to public transit.”
As a private REIT, Equiton is an active real estate investor that provides its clients passive investment opportunities. Moreover, it focuses on creating passive real estate investment funds for clients that have earned 7-12% cash flow and share price returns. In addition to investing in the multifamily residential sector, Equiton is involved in the commercial and industrial sectors, real estate development and lending.
As such, the company is a big believer in stringent due diligence.
“If you’re looking at buying an income-producing asset, whether multifamily, commercial or industrial, you want to have a good understanding of the building itself but also of the neighbourhood and the city that the building is in,” said Fraser. “You want to look at competitor buildings in and around the neighbourhood and how they’re operating. Have there been nearby sales recently—you can compare pricing that way—but because income-producing assets are a business, you have to know what kind of revenue it will generate, what kind of expenses it will incur, and what the leverage is. If you get a mortgage on the property, you want a competitive rate but you don’t want to overleverage yourself, either. The cost of borrowing is cheap, but you will kill the cash flow if all the money you generate from the NOI goes to feed the monthly mortgage payment.”
Equiton uses its strong relationships with lending institutions to secure favourable rates on projects, which is especially attractive for investors considering that multifamily dwellings composed of over 40 units may qualify for commercial mortgages.
Fraser says there are other ways to augment a multifamily investment property’s value, and while the savings might not manifest immediately, rest assured the building’s expenses will decline in time.
“Again, when trying to understand a property’s potential value, pull back the curtains and understand the true net operating income opportunity. Just because somebody runs their business at a 5% return, it doesn’t mean yours can’t be higher. See what you can do to extract more net operating income from the property,” said Fraser.
“Look to see if there are opportunities to increase the rent, which might come through making improvements to units or by simply asking for market rent. There are also opportunities to increase non-rent revenue items, like charging for parking or utilities. There are ways to reduce expenses, which takes longer to get the full payback, but you can use low-flow toilets, LED lighting, or you can use energy efficient windows and appliances. Those are some of the things that owners neglect to take into consideration that are also good for the environment.”