So, you think you know cap rates

By Bruce Firestone | Entrepreneurship

Nov 21

OK, you are a real estate investment whiz. Then see if you can answer this question about cap (capitalization) rates:

THE QUESTION

Let’s say you buy a duplex for $500,000 and it has a going-in NOI (net operating income) of $26,500 per year. That’s without any renos, new leases, or animations, ok?

This is a going-in cap rate of 5.3%, hence below my target of 6%.

Therefore, maybe you should not have paid more than $26,500/6% or $441,667, right?

Anyway, you paid more than you should have but there it is—an asset of $500k and a cap rate of 5.3% pa.

In year two, you add a backyard workshop for $120,000, one storage shed (with two leasable spaces) for $5,500 and you add tech packages to new leases (three of them—one for each tenant in your duplex and one for the workshop tenant).

You get $895 for the workshop a month and $85 a month for each storage compartment and $105 for each tech package so your GOI (gross operating income) has gone up $1,380 a month or $16,560 pa. Your net from this is say 66% of $16,560 or $10,929.60.

So, total NOI is now $37,429.60 pa on a cost base of $625,500; hence, your cap rate is now 6% 😊

However, this is where it gets more complicated.

Let’s say you can convince an appraiser that the FMV (fair market value) cap rate in your area for this type of asset is 4.5% and s/he agrees so that s/he values your property more like a commercial than residential property, viz:

$37,429.60/4.5% or $831,769

“Hallelujah,” say you.

Now, you refinance it at 80% LTV (loan to value) so you have a new mortgage of $665,415. Let’s assume your old mortgage was 80% of $500,000 and 80% of reno costs or a total of $500,400. Let’s also assume two or three years have gone by and your principal has been reduced by about $25k. So, you have a balance owing on the old mortgage of $475,400; your new mortgage is $665,415 so you have cash on hand tax-free of $190,015 less any fees or costs you incurred in paying off your old mortgage and getting a new one (an appraisal fee, legal fees, possibly mortgage broker fees…)

So, with that $190,015 you have enough equity (cash) on hand to go out and buy another duplex in a rinse and repeat, buy ‘n hold formula that creates a perpetual motion machine that really works.

Alright, a few more years pass.

Your NOI on your original income has increased to $43,500 pa (from $37,429.60). What is your cap rate?

  1. Do you use your original cost base PLUS RENOS of $625,500, or
  2. Do you use your FMV appraised value of $831,769?

Your answer?

Let me know what you think it is: bruce.firestone@century21.ca

The answer is here, https://www.dropbox.com/s/7kc6sd7hf83ostg/how-to-properly-calculate-cap-rates-2019-Peter-Pomykacz-answer.pdf?dl=0

Please also refer to: https://brucemfirestone.com/do-you-use-historical-prices-or-fmv-when-calculating-cap-rates/

Prof Bruce

FOR REAL ESTATE INVESTMENT AND BUSINESS COACHING THAT’LL HELP YOU PROVIDE FOR YOURSELF AND YOUR FAMILY FOR 3-GENERATIONS, PLEASE CONTACT:

Bruce M Firestone, B Eng (civil), M Eng-Sci, PhD
Real Estate Investment and Business coach
Century 21 Explorer Realty Inc broker
Ottawa Senators founder
1-613-762-8884
bruce.firestone@century21.ca
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Bruce is an entrepreneur/real estate broker/developer/coach/urban guru/keynote speaker/Sens founder/novelist/columnist/peerless husband/dad.

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