Do you use historical prices or FMV when calculating cap rates?

It’s complicated.

A client of mine is doing a PAAN (property animation and analysis report) for a client of his. He writes and asks me the above question. Here below is my response…

That is an excellent question, David. Truly.

The honest answer?

It depends.

Say you bought a home in Ottawa in 1980 for $62,748, which was the average sale price in that year (source: https://www.homesinottawa.com/site/Pages/history-of-average-house-prices.html)

You could probably rent that today in 2019 for $2,100 a month or $25,200 a year GOI (gross operating income). Your NOI (net operating income) will be about $25,200 x (1-.34) or $16,632 pa. That is, around 34% of your GOI is used up for property taxes, insurance, utilities, repairs, maintenance, make-ready costs, vacancies etc.

So what is your cap rate?

$16,632/$62,748 = 26.1% pa

Based on historical costs that is true, but there is also an opportunity cost to consider.

So, as of 2018, assume the FMV of that house has risen to around $407,571, which means your cap rate could also be:

$16,632/$407,571 = 4.1% pa

Which is it?

I could mount arguments for and against both numbers but for me, I’d use the latter.

That’s why many realtors, analysts, financial advisers, financial planners, economists, bankers, lawyers, accountants, consultants, coaches(!), mortgage brokers, executors, trustees recommend selling real estate at this point—to seize better opportunities elsewhere. But what they don’t tell you is that those other opportunities are mostly self-serving crap (mutual funds, life insurance, stocks, bonds, RRSPs, TFSAs, 401(k)s, etc) that they’ll sell you so they can make a commission/fee even though your returns are likely to be terrible.

My advice?

Find ways to animate that property and increase your current value cap rate from 4.1% to at least 6% pa knowing as you do that in addition to your cap rate ROI (basically measuring cashflow), you have property appreciation (in Ottawa that’s heading towards an amazing 8% pa) and, if you have a mortgage, a wealth effect from having your tenants pay off your mortgage for you over time.

Does that help?

Cheers, Bruce

ps the actual situation in most cases is more complicated. Say you bought that place in 1980 for $62,748 but added a basement suite in 2017 for $100,000. Now, you are in a real quandary—do you use an historical cost of $62,748 + $100,000 or still use the FMV of $407,571. And there is one more question to ask: Did your FMV change because you added the basement apartment? Is it $407,571 + $100,000 or maybe even $407,571 + a percentage of $100,000 (because sometimes the cost of improvements is not fully reflected (at least in the short term) in appraised value).

Bottom line: financial analysis is still an art (not a science) and you need to use JUDGMENT 😊

Lastly, every project, every report, everything human beings do is an act of faith. No matter how smart you are or how much analyzing you do, at the end of the day, you do a project/make an investment because you have faith it’ll all work out, right?

Bruce M Firestone, B Eng (civil), M Eng-Sci, PhD
Real Estate Investment and Business coach
ROYAL LePAGE Performance Realty broker
Ottawa Senators founder
1-613-762-8884
bruce.firestone@century21.ca
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