Investment First-Timers: A Primer

As the commercial and residential markets continue to heat up, many are looking to
leverage their equity and purchase their first investment property. For many, they look to
capitalize on the state of the residential market and purchase a multi-unit property, improve the
building, and increase the net income through higher rents or low operating costs. Others look
to carry out a similar strategy through commercial and retail units. Often times, investment
properties with such commercial units may offer a better rate of return, but may however also
require more investment in the forms of both time and money.

Before a buyer can enter into such a purchase, there are a few terms and concepts they
should be made aware of. The reader here should be aware, however, that the following is not
an instructional manual, step-by-step guide, or exhaustive list – simply a discussion of some of
the more prevalent language and ideas necessary to understand commercial real estate and
investment properties.

Capitalization Rate

Much of the time, a glance at a property listing in this magazine or on ICX will yield a
capitalization, or cap, rate. A cap rate is used to determine the rate of return on an investment
property based on what income the property may be expected to generate. Generally, the
higher the cap rate (usually denoted as a percent), the better the investment (or at least, rate of
return). A cap rate is derived by taking the Net Operating Income (NOI) of the property and
dividing it by the list or asking price. For instance then, if a property has an assessed value or
list price of $750,000 and an NOI of $75,000, the cap rate on the property would be 10%.

Income, Expenses, and the Upside Factor

Determining the cap rate on a property is a relatively simple process, in theory. In reality,
there are many factors that can go into determining it. More specifically, there are many factors
that may influence or determine the NOI on a property. For instance: How much rental revenue
is generated annually? What is included in the rents? Do tenants pay for utilities or TMI (taxes,
maintenance, insurance) separately or are they included in their rent? In other words, are some
leases gross leases, where the majority of expenses are included in rents, or are they net
leases, where tenants are expected to pay TMI and added expenses on top of their rent? These
are such factors as may determine the level of income on a property, and why a period of due
diligence as coordinated by your commercial Realtor is incredibly important for a smooth and
profitable commercial deal.

On the other side, the expenses associated with a property can often amount to higher
than upon initial inspection. Property taxes, building insurance, utilities – these expenses can
significantly affect the NOI associated with a property. Other expenses, such as property
management, rental items, repairs/maintenance, and vacancy/bad debt can all negatively impact a property’s retained revenue. As a result, a buyer should be aware that expenses for a property can run higher than when numbers and figures are initially presented. This is not to say that an initial cap rate or NOI provided by your Realtor will not be accurate or prove to be
completely true – this is to advise caution and ensure that you as a buyer check and re-check all
numbered items. If at first glance a property is being presented with a cap rate of 6% but is
revealed to have a cap of 5% during a due diligence period, a deal may be put at significant risk.
If a property has a net income of $50,000 but is later on revealed to have an NOI of $40,000,
the value of the property would be significantly impacted. A $10,000 shortfall in net income at a
cap rate of 5% would result in a value difference of approximately $200,000. From a seller
standpoint, this means being as thorough and transparent as possible from the outset, in order
to avoid problems and wasted time further into the deal.

The Ideal Cap Rate

This is where things get tricky. Different types of properties in different types of areas
may yield a completely different ideal capitalization rate. In Toronto for instance, the average
cap rate for a low-rise apartment building is approximately 4%. In Vancouver, meanwhile, a
similar property would likely yield a cap of 3.5%, and in areas such as London or Windsor an
investor may encounter cap rates on such properties averaging as high as around 6.5%. In
Hamilton, we have the advantage of being around the median point of the above figures, with
cap rates for low-rise apartment buildings generally falling around the 5.5 or 6% marks.
There are other factors that may substantially affect the value of a building, such as its
age, zoning, or location, through their effects on income and expenses. For example, if an older
low-rise apartment building along Locke St. (one of the most popular areas here in Hamilton) is
up for sale at $2 million but only has an NOI of $80,000 (creating a cap of 4%), it’s unlikely that
potential buyers may be interested. But if the 1-bedroom residential units within this building are
currently being rented for $750-$800 a month when market rents are in fact closer to
$1,200-$1,300, there is potentially massive upside in the form of the future cap rate.

Your Investment

Many investors and even first-time commercial buyers are well aware of how to read a
capitalization rate, but not everyone is aware as to the specific factors and metrics that may go
into the determination of a cap. Income, expenses, asking price, and the factors that comprise
them, all play a role. When contemplating a purchase of a property or asset, it’s then obviously
of the utmost importance that your commercial Realtor or representative acquire as much
information as possible in order to give you the best insight as to whether it’s a good buy or one
best to walk away from. If you would ever like assistance in finding such a deal, please feel free
to contact me or my team!

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