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Phone: 519-435-1600

Valuating Income Properties London Ontario

                                  Cap Rates- The Most Misunderstood of All

  Cap rate (CR) is arguably the most often quoted metric for expressing property value. Yet, it tells only half the story.

  Facts & Figures Investing Real Estate London Ontario

 Why is there such emphasis on CR? Because it allows you to financially compare two widely differing rental properties. A poorly managed nine-plex could be less profitable than a well-managed six-plex.

 CR expresses the relationship between a property’s current year’s net income and the property’s value. It helps but doesn’t completely determine the value of an investment property and its potential return on and of an investment.

 CR is calculated by subtracting all operational expenses (excluding financing and capital expenses), plus vacancy and bad debt from the property’s total income and dividing the result – called net operating income (NOI) – by the current value or sale price of a property. It’s expressed as a percentage. There’s a mathematical inverse relationship between property value and CR: the higher the CR, the lower the property value and vice versa. Buyers want a high CR. Sellers want to offer a low CR. The buyer’s higher rate of return is reflected by the seller’s lower sale price.

 Listings may cite CR but often exclude or include expenses that a lender doesn’t care about or that are not actually an operating expense. The most common “missing” expenses are repairs and maintenance, property management and vacancy and bad debt. Excluding these expenses make a CR look much better than it is. Because of that, lenders add in missing expense approximations, which then drive property value down. This in turn reduces the mortgage amount and the deal “fails because of financing”.

 For example, a property generates $100,000 in annual gross income. The listing states total operating costs are $35,000, generating $65,000 NOI. Divide NOI by five per cent CR = $1,300,000 baseline property value. You expect to receive 75 per cent of the value as a mortgage, called loan-to-value (LTV) = $975,000.

 However, the listing didn’t include vacancy/bad debt (typically two to four per cent), repairs/maintenance (typically $750 to $800/unit) and property management (average five per cent). The property’s expenses are actually $45,000, generating $55,000 NOI, divided by five per cent CR = $1,100,000. Therefore, the lender’s $10,000 in added expenses reduced the property’s value by $200,000. Seventy-five per cent LTV = $825,000 mortgage, which is $150,000 less than you expected. Unless you can come up with that difference, the deal fails.

   Cap Rates- Income properties London Ontario

 CR can provide solid insights into a property’s financial performance, but because CR is based on NOI, it doesn’t factor in financing and closing costs so it won’t tell you how much profit (cash flow) you’ll make.  It doesn’t consider a property’s state of repair, so you may have to invest extra money into major capital expenses such as windows or a boiler. It doesn’t project appreciation or geographic growth potential or consider local crime rate and types; tenant demographics; the quality, construction, size and age of a property; or the property’s proximity to amenities. CR doesn’t forecast increases in operating and financing costs, possible right-of-way issues or environmental concerns.

 When a buyer declares in a “5.0 cap” market that they will only look at properties with a 6.0 cap, they’re saying they want a property with a high NOI at a deeply discounted purchase price. Well, shucks and golly gee, don’t we all want that? Such buyers are looking for bargain-basement investment properties they’re unlikely to find and they’ll never make a purchase.

 A property’s market value generally assumes it’s in a good state of repair, the land is employed for its “highest and best use,” and its rental revenue reflects all the local positive and negative market influences. The market assumption is that the buyer won’t have to lay out any immediate cash for capital costs.

 No seller should expect to receive market value for their property if any of the above isn’t true. To expect otherwise, the seller is saying they want you to pay for the property’s future potential even though the seller did nothing to deserve a share in that future potential. If a seller wants to benefit from that potential, they should invest the time and money to first realize that potential and then sell their property.

 A seller might purposely offer a higher CR if the property is “stigmatized” and requires a buyer who doesn’t care about the stigmatism, or it may be “distressed”, requiring a notable influx of cash to fix the problem.

The above was written by Chris Seepe, a published writer and author, ‘landlording’ course instructor, president of the Landlords Association of Durham, and a commercial real estate broker of record at Aztech Realty in Toronto


How Much Is This Property Worth?

  You would be amazed at the number of investors who do not know how to determine the value of real estate.As an investor, it is crucial that you are able to determine value for yourself and not leave it up to someone else.

Income Properties London Ontario

The three primary yet different ways of determining value with real estate are the CMA, the Income Approach method and the Replacement Cost method.

                           3 ways to value a property in London Ontario

The CMA method (What most REALTORS use)

The CMA (Comparable Market Analysis) method is based on what similar or comparable properties have sold for in the past, typically within the last three months.

The CMA is the most common valuation method for residential single-family homes. However, it's typically the least favourable valuation method for investment real estate.

The Income Approach

The Income Approach method of valuation puts a value on the income generated from the property. This is the valuation method investors use most when evaluating an income property.

The Replacement Cost

This  method of valuation is simply what it would cost to buy the land today and build a new building with the same square footage with similar features.

Let's use an example to illustrate the differences between the valuation methods and assume for a moment that we are talking about a three-bedroom home with a two-bedroom basement suite.

The main level of the home is 1,000 sq ft and so is the basement for a total of 2,000 (finished) sq ft. The home is occupied by the seller and the seller collects $1,000 per month from the suite and the tenant pays for their portion of utilities in addition to their rent.

                                           What is the price of a home in London Ontario?

The seller is asking $400,000 since a Realtor told the seller that the CMA (Comparable Market Analysis) showed that similar properties in this neighbourhood have recently sold in this price range. This is the CMA value which is again what the market is currently willing to pay.

We can determine what the income is worth from an Income Approach method of valuation. Since the seller occupies the main house and we know the market rents in the area, we can quickly estimate that the home would rent for $1,500 month plus utilities.

Including the suite income of $1,000 we would have a total of $2,500 in total gross income. We then deduct all of the expenses, not including financing.

Let's assume that we have calculated the property taxes, insurance, vacancies, advertising, management, repairs and maintenance and a monthly miscellaneous allowance totalling $900 in monthly expenses. That leaves $1,600 ($2,500 - $900) remaining each month which is the amount left over to pay a mortgage.

By running a simple mortgage calculation based on $1,600 per month for a mortgage payment using a 25-year amortization and a 4% interest rate, the amount of mortgage that a $1,600 payment can support is $304,000. Adding a 20% down payment of $76,000 on to the mortgage amount would give a maximum Income Value of $380,000. ($304,000 + $76,000).

Pretty simple isn’t it, yet 90-95% of people who I see in my office have used the CMA approach or as an example, when I show properties, I review what the previous owner had purchased the property for and guess what?


Note: Paul Hecht, an investor, wrote most of this article, the italics are my words!No wonder they were losing money and are discouraged!

London Ontario Real Estate Investing Insider

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