CAP RATES 101

One of the most desirable places in the world for real estate investors to buy property are Vancouver and the Lower Mainland. We’re consistently ranked as one the most “livable” cities and we all know there’s only so much “livable” land to go around. If you have the capital, you’re virtually guaranteed a profitable return on your property investment here. The rate of that return is expressed by investors and brokers as the capitalization rate, or cap rate.

The cap rate formula is simple: you take the net operating income of a property (NOI) and divide it by the market value of the property, then multiply by 100. So it looks like NOI/Market Value X 100. But it’s a tricky science determining these factors, and then applying a reliable cap rate to a property that investors and brokers can depend on.
 

We spoke with Daniel Greenhalgh, one of our co-founders here at ENM Construction Management, and he provided some insights into the complexities of the cap rate.
 

“The essence of a cap rate is a reflection of risk in the market that it is being applied. The more mature the market, the lower the risk, and therefore the lower the cap rate someone is willing to accept. Think of it as your return on your investment -- so if you want a safe investment, then the interest rate you will be able to earn on that investment is likely the lowest rate. As the risk of the investment increases, so does the interest you are likely to earn. For example: If you want to earn a million dollars a year, you would need to look at the cap rate to figure out how much you would need to invest. In a really safe and mature market like Vancouver, which has cap rates in the range of 2.5 to 3.00, you would have to invest forty million at 2.5 (1,000,000 divided by 2.5%). In another market where cap rates can range from 7% to 8%, you would have to invest 14,285,714 to make your million.”

Daniel points out that nearly all Tier 1 and 2 banks and credit unions reference the Canada Mortgage and Housing Corporation (CMHC) to establish cap rates for their properties. But this is still an imprecise measure, and many brokers attempt to apply cap rates to their property using rates from similar transactions. A recent article in Western Investor points out the folly of this approach.
 

The article stresses that aside from the availability and quality of a product, the most important variable in determining a cap rate is the interest in the property by foreign investors.
 

We all know that purchases of B.C. property by foreign investors are at an all time high. It seems that no matter how high the prices go, there will be willing buyers snapping them up. Vancouver cap rates are lower than the national average in every property category. But even with these cap rates, both foreign and domestic investors still flood the markets. In such an inflated market, it’s nearly impossible to accurately determine a cap rate.