I recently worked with a couple who are looking to build a real estate portfolio of residential revenue properties. Prior to working with me they attended a few seminars specific to the topic of calculating capitalization (“cap”) rates for the purposes of real estate investing.
I am pleased to announce they have purchased their first multi-tenant building but not without dispelling their approach to purchasing revenue generating property based solely on cap rate.
Firstly, what is a cap rate when it comes to real estate investing?
Definition of ‘Capitalization Rate’
Capitalization rate is a rate of return on a real estate investment property based on the expected income that the property will generate. Capitalization rate is used to estimate the investor’s potential return on his or her investment. This is done by dividing the income the property will generate (after fixed costs and variable costs) by the total value of the property. If you want to get technical, it is basically the discount rate of a perpetuity.
Factors to consider when purchasing a property for rental purposes
There are a multitude of factors that should be considered when purchasing a duplex, triplex or single family dwelling for rental purposes, beyond just capitalization rate. These include:
Where is the property located?
This is important for two reasons. Firstly, where a property is located dictates the type of tenant that it will attract, how much rental income the property will generate, and the turnover in tenancy. Secondly, where a property is located affects the appreciation in value over your investment lifetime.
How many properties do you have in your portfolio?
A cap rate is a measure of the cash flow you are achieving from your property, but when you take into account the maintenance derived from tenancy turnover and regular real estate maintenance, it is difficult to get an annual rate that is stable from a small portfolio of less than 12 rental units. If a portfolio suffers a property that has unexpected maintenance issues, it can substantially affect the cash flow in a very specific year, but over a period of 10 years would be more easily absorbed by consistent revenue from the other properties in the portfolio.
Get the right advice
When thinking about revenue generating properties it is important to understand the mechanics of management, the legal implications and exposures attached to tenancy, as well as the financing restrictions on this specific type of property.
Don’t be fooled by the lure of the cap rate advertisement; there are many factors to consider. Real estate can be a great long-term investment if you are getting the right advice. Ask yourself: Does your realtor have a background in both the legal industry and asset management?
The answer should be yes.