We’re breaking this week’s article into two parts: one part data, and one part theory.
The first part provides some recent market data to show cap rates based on 2018 sales in the Greater Edmonton area. Of the 190 total investment sales last year, The Network was able to acquire cap rate data on 116 of the properties. We categorized the properties into asset classes to show the corresponding cap rates.
The second part is a deeper dive into commercial real estate analysis. While cap rate is a ubiquitous real estate term, not everyone understands exactly why it is so important, how it’s calculated, or what limitations exist.
2018 AVERAGE CAPITALIZATION RATES
Hotel / Motel: 7.93
Here’s some more information on the data set:
25 properties with a combined sale price of $390 M
Average Cap Rate: 6.86
Low / High: 5.98 / 8.19
36 properties with a combined sale price of $421 M
Average Cap Rate: 6.31
Low / High: 4.06 (city of Edmonton annexation) / 8.16 (court ordered sale)
5 properties sold for $422 M. Interestingly, one property (Edmonton Tower) made up $400 M of that total.
Average Cap Rate: 5.89
Low / High: 4.3 / 7.91
9 high rise apartments, 34 walk ups, 1 row house and 6 mixed (walk up / retail) with a combined sale price of $470 M
Average Cap Rate: 5.22
Low / High: 2.76 / 8.84
HOTEL / MOTEL
2 properties sold for $18.6 M
Average Cap Rate: 7.93
ABOUT CAPITALIZATION RATES
Okay, you’ve been warned, here comes the theory.
Capitalization rates are classic back-of-the-envelope calculations (meaning the math is fairly straightforward).
Knowing any two of those numbers allows for quick calculation of the third. Having an indication on what the prevailing cap rate is will allow an investor to calculate an approximate value of a property simply by dividing it into the Net Operating Income.
A key aspect of the cap rate calculation is that it implicitly assumes the Net Operating Income will remain constant in perpetuity. If we look at cap rates as being comparable to an investment’s rate of return or yield, we can compare it to the formula used to determine the Present Value of a perpetuity:
or more simply:
Adjusting the formula shows that the discount rate (r) is equal to the Dividend (income) / Present Value, which is comparable to the cap rate formula.
Discounting future cash flows back to a present value might sound like an intimidating concept but it is predicated on the simple notion that $1 is worth less in the future than its worth today. Intuitively you would prefer $1 today as inflation will (likely) erode that same $1 if you were to get it down the road, not to mention the inherent risk that you might not get it at all. Continuing on with this logic, $1 is worth less one year from now, even less two years from now, and so on (assuming you look at it strictly from today’s perspective). On that basis, Net Present Value is the sum of all positive and negative cashflows (think money going out towards the purchase price and money coming back in the form of rent and the sales proceeds at the end of the projected holding period). The Internal Rate of Return is the rate taking into account all the cash flows (and mathematically is the rate at which the Net Present Value is equal to zero). While this is a high level overview, DCF analysis is a complex topic. If you’re interested in the topic there are plenty of courses available. We recommend either the online real estate program through UBC or the 101 course through the CCIM Institute.
With the assumption that the income remains ad infinitum, it starts becoming clear that it has potential limitations. After all, it does not take into account increases (or decreases) in rent, nor does it account of changes in the value of the property itself. Presumably, properties located on the north end of downtown Edmonton saw a noticeable uptick in value as soon as Rogers Place was announced. The rents didn’t necessarily change over night, but the value of the buildings themselves likely did.
Furthermore, the cap rate does not allow any accounting for financial leverage or taxable benefits. A buyer who can purchase a property using positive leverage will, in theory, outperform a buyer who purchased it without any leverage. Different buyers will also have different tax positions, but the cap rate technique ignores this variance.
Even outside of ignoring these important components, determining what the prevailing cap rate actually is can be quite complex. In the numbers we used above, there was a considerable spread between some of the highs and lows, so using an average isn’t necessarily accurate. Small deviations in the cap rate can have a dramatic impact on the property’s “value”. For example, assume a property has $100,000 in Net Operating Income. If one investor applied a 6.25% cap rate it would give an approximate value of $1,600,000 whereas another investor who used an 8.0% cap rate would peg it at $1,250,000. Same property, $350,000 difference in opinion. Also, the term “value” is a bit ambiguous. Does it refer to market value, asking price or the sale price? In the data above, it all refers to sale price, but an argument could be made that it is not an accurate representation of market value. For example, one of those sales might have been made under duress (ie/ foreclosure) or perhaps even be a non-arms length transaction (ie/ sale of a property from the company to the company’s founder).
It’s also worth asking how the Net Operating Income is calculated. Is it actual income, and if so, are the rates at market? Or is the rental amount based on what is believed to be the “market” rate? Furthermore, does it account for the period it sits vacant and / or the costs required to secure a tenancy? Is there an amount deducted to allow for vacancy and credit loss? Is there amount allocated for structural reserves? So many questions, so many different ways to calculate!
In summary, cap rates are undoubtedly a great tool and there are reasons why it’s so commonly used. Cap rates, however, should be viewed through the lens of healthy skepticism and even considered as a precursor to more advanced real estate analysis.
Information contained herein has been obtained from sources deemed reliable but is not warranted to be correct and is subject to change without notice. Nothing contained herein should be construed as real estate or investment advice and should not be relied upon for any purpose. We used best efforts in compiling and analyzing the data based but do not warrant the outputs to be accurate. We used the arithmetic mean for calculating the averages. Our full disclaimer is available here.
Chad GriffithsPartner, SIOR, CCIM
Chad is a partner with NAI Commercial Real Estate and focuses on the Greater Edmonton area. Chad entered the industry in 2004 and has completed over 400 commercial transactions with clients ranging from small, local companies to large institutional owners. Chad has been a top 15 producer with NAI Canada-wide since 2013.
Ryan BrownPartner, BCom, SIOR
Ryan is a partner with NAI Commercial Real Estate in Edmonton and is currently ranked nationally as one of NAI's top advisors. Having executed in excess of $100 Million worth of sales transactions and over 2 Million square feet of lease transactions, Ryan has developed a firm understanding of asset evaluation and an aptitude for building design, functionality, and long-term practicality.
Darcie is a licensed Commercial Real Estate Agent in the Province of Alberta with a focus on the Edmonton market and its surrounding areas. Darcie accomplishes custom solutions for her clients through her personable nature and results driven attitude. Darcie can help if you are looking to invest in commercial real estate or are looking for representation for a sale or lease transactions.
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