Understanding Cap Rates: What Real Estate Investors Need to Know
Adrian C. Spitters FCSI?, CFP?, CEA? President, Author, Private Wealth Advisor
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The Impact of Cap Rates on Canadian Real Estate Investment
Investing in income-producing real estate is a complex task, especially when it comes to understanding capitalization rates (or "cap" rates). Cap rates have steadily increased among most Canadian property types in recent years, particularly in key markets like the Greater Toronto Area. This rise has prompted hesitation among real estate investors. It's crucial for financial advisors and investors to understand what cap rates really represent and how they are used in valuing real estate properties.
Cap Rates and Net Operating Income
Cap rates are only part of the equation when determining a property's value. Another critical part to consider is net operating income (NOI). In simple terms, a rise in cap rates can result in a decrease in a property's value, but only if NOI is held constant. However, NOI is influenced by factors such as turnover, occupancy rates, rental increases, and operating efficiencies. These can fluctuate depending on how a property is managed and market conditions. Understanding a property's overall performance is key to determining its true value to an investor.
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Cap Rates: Just One Piece of the Puzzle
For advisors evaluating a private real estate fund, focusing solely on an asset's cap rate overlooks other important factors that can affect the investment. Cap rates offer a snapshot of a property's value at a specific moment in time. According to Jason Roque, CEO of private equity firm Equiton, “It’s critical to understand that cap rates are just one piece of a much larger puzzle. It’s important to take a holistic approach and look to the future.”
Cap rates are not sufficient for comparing properties across various categories of real estate. For example, cap rates for multifamily properties will not produce an effective comparison with industrial, commercial, or detached residential properties. Moreover, using cap rates within a real estate category for comparison across markets or regions may not be accurate due to differing economic conditions.
The Importance of NOI and Active Management
A focus on NOI and finding methods of improving revenues within a portfolio is a key approach that savvy real estate companies can use to offset the effects of rising cap rates. For instance, the cap rate of Equiton’s residential income fund trust (apartment fund) increased by 0.50 percent between Q2 2022 and Q1 2024. However, a roughly 20 percent boost to net operating income, driven by portfolio market rent increases and a robust operating margin, helped the firm grow the fund’s fair value by 5.8 percent within that same period.
Roque emphasizes that “Firms with an active management approach can really stand out in a high cap-rate environment for the value they can unlock.” Equiton’s in-house property management arm, Equiton Living, enables the firm to build close relationships with residents and find opportunities for strategically improving property values.
The Multifamily Advantage
Not all property types are equally affected by higher cap rates. For example, according to CBRE’s latest Canada Cap Rates and Investment Insights report, multifamily residential cap rates held stable in the first quarter of 2024. This sector’s resilience is attributed to increasing demand for housing, rent growth, and population growth due to immigration. The Canada Mortgage and Housing Corporation (CMHC) reports that home affordability challenges continue to buoy the multifamily sector’s growth. The national average home price could exceed previous records by 2025, and 2024 could see record rental occupancy and rent increases on unit turnover.
In June, the Bank of Canada lowered its key interest rate by 0.25 percent, with further reductions predicted this year. A drop in interest rates can lead to a decline in cap rates and new opportunities to increase NOI. As economic conditions improve, the Canadian multifamily sector continues to present significant opportunities for advisors and real estate investors. Roque notes, “Taking a long view of real estate investment means committing to a strategy designed to weather challenging conditions. That positions you for sustainable growth when the markets are strong.”
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Adrian C. Spitters FCSI?, CFP?, CEA? President, Author, Private Wealth Advisor
I Execute Tax-Efficient Investment Portfolio Solutions So That Your Business, Family, And Estate Assets Are De-Risked And Protected Against Financial Risk, Economic Threats, Inflation And Higher Taxes.
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