CAP rate is an important metric to consider before buying any investment property. It measures the rate of return on a revenue property, based on current income and market value.
Capitalization Rate (Cap rate) = Net Operating Income (NOI) / Current Market Value
Net operating income (NOI) measures the net income on the property after all operating costs have been accounted for, and the current market value of the property is calculated using a compartive Market Analysis (CMA).
Let’s take a look at average CAP rates in Montreal:
According to Cushman & Wakefield‘s latest CAP rate report (Q2 2018):
- Apartment buildings recorded average CAP rates of 4.25% to 6.00%. Low rise buildings performed better than high rise buildings.
- Downtown office spaces recorded average CAP rates between 4.50% – 6.75%. The highest CAP rate (6.75) was seen in class “B” types – older office products, typically in the range of 100,000 to 250,000 SF. Shorter lease commitments occur in this asset class with the average term ranging between 5 and 10 years.
- Retail buildings recorded CAP rates ranging between 4.50% – 7.50%. The best CAP rate was among non anchored strip plazas.
- Industrial buildings recorded average CAP rates from 5.75% (low) to 7.50% (high). The higher CAP rate was for older suburban products that attracted a wider range of tenants and covenants for lease terms ranging between 3 and 10 years.
- Suburban office spaces ranged from 6% to 7.5%.
- Hotels recorded CAP rates between 7.00% to 9.5%. The highest CAP rate was for limited-service suburban hotels.
How should investors interpret CAP rates?
- Low cap rate: A building with a low CAP rate isn’t always a bad investment. Low cap rates can be a result of poor management in the past, or may indicate that the building needs renovation work to reach its full financial potential. Investors should consult with a broker to investigate whether current CAP rates match up with market averages, and whether there is room for upside.
- High cap rate: A building with a high existing cap rate is already generating healthy income in respect to its market value. Buying into a building with a high cap rate ensures a “turn-key” investment, meaning you won’t need to renovate or restructure the building.
To project potential CAP rate, an investor should take into account:
Location and average rental rates
Location is key when buying a rental property, because location drives demand.
Research average rental rates in the building’s borough and on the building’s street, by looking at rental market reports or by consulting with your real estate broker.
If existing rental rates fall short of average rental rates in the area, you will want to investigate further and find out why. Does the building or the apartment units need work? How much will renovation cost? Has the building been poorly managed in the past?
Answering these questions will help you understand how much “upside” the building offers, and what your potential CAP rate could be.