A friend of mine sent me the following email the other day regarding his interest in purchasing a multiunit residential real estate property:
Just started my search. These are all quite close to me personally. The last one, in particular, looks appealing as it’s very close to the subway and appears to have below-market rents.
How should I think about these from a pure dollars perspective in terms of the ROI?
Frankly, this topic goes well beyond what I can write about in a thousand-word blog post, but I’ll at least point my friend, and hopefully my readers, in the right direction with this post.
It Starts with the CAP:
I wanted to share with you a simple but often misunderstood concept that is the first thing you need to know when moving into the investment real estate market. Now, don’t get me wrong, finding an amazing income-producing property and then negotiating the financing and purchase of it takes a lot of work and skill. But before you begin the hunt, you need to understand this one thing.
At the heart of investment in real estate is a concept called CAP (capitalization rate).
For those who have read my book, (free through this link) The Kickass Entrepreneur’s Guide to Investing, I cover this in some detail, so you’re likely already familiar with CAP rate. For those who haven’t, I cover the basics of CAP rate below. Note: some of the information below is copied verbatim from my book, but I go into it in much greater detail there.
Follow along with some of my calculations. I’m going to show you how an improvement of $1 in profit in your property can produce a $25 increase in your net wealth.
The CAP rate is the building’s profit, before taxes and building depreciation, divided by the purchase price of the building.
Here’s the formula: CAP rate = Net Operating Income (NOI) ÷ Building Value (BV).
For example, say the real estate value of a building is $1 million. After expenses, the NOI, not including mortgage, debt repayment, or interest charges but before taxes, is $60,000. The property’s CAP rate therefore is 6%: $60,000 ÷ $1 million = 6%.
Why is this number so important?
All rental property trades on the CAP rate, so that’s the first thing a discerning buyer should look at when buying or selling a building.
CAP rates vary by city, neighborhood, pockets within a neighborhood, and current market conditions. A building in one section of a city can trade at a 4% CAP rate, while at the other end of the city a similar building can trade at 7%. Two blocks over and you might be trading at 6%. So although there is some subjectivity associated with the CAP rate, it’s quite defined.
At the moment, the average CAP rate of a multiunit residential (MUR) building in North America is about 5.5%. The average CAP rate of a MUR in Toronto is approximately 4.5%, however, I’ve seen many properties trade in the 3% range (and even lower).
Now let’s do some backward math. If I told you a building’s NOI is $100,000 and the building has a CAP rate of 5%, we could determine the value as follows:
CAP rate = NOI ÷ BV
5% = $100,000 ÷ BV
BV = $2 million
Although there are many ways to make money in investment real estate, here’s an example of how some creative math can make big dollars.
Let’s say you were able to increase your building’s revenue by $1 (by raising rents or lowering expenses by $1). Your net operating income for your building has now increased by $1. At a 5% CAP rate, for every extra dollar in NOI, you increase the value of your building by $20.
Let me illustrate with a story:
In 2014, I got a call from my insurance company about the 21-unit building I own. It turned out they no longer wanted to insure the property unless we removed all knob and tube electrical wiring from the units. Knob and tube is an older type of electrical wiring that was used up until the 1930s, and insurance companies are reluctant to insure buildings with that wiring because of a perceived increase in risk. I had two months to comply, after which I needed to sign an affidavit confirming the building no longer contained knob and tube. Otherwise, I needed to find a new insurance provider or I was screwed.
Only two of the units had such wiring, so you’d think it wouldn’t be a big issue. The problem is, both were occupied and well below market because of their rent-controlled status. A good deal for the renters, not so much for me. It was going to cost thousands to replace the wiring, patch all the holes, and repaint. At that point, I could spend a few extra dollars to retrofit the units entirely.
The tenants in those two units were paying $900 per month each in rent, and the going rate for a retrofitted unit in the same building commanded a rent of at least $1,500 per month, a difference of $600 per month, or $7,200 per year per unit.
I couldn’t kick the tenants out. I had the option of asking them to leave for two months while I retrofitted the unit, but once done, because of rent control, I would have to give them their units back at the same rent. It just didn’t make sound financial sense.
I ended up paying the tenants thousands each to leave their units. All in, including the fees to vacate the units and the upgrade costs, I spent at least $45,000 per unit and rented the renovated units at $1,500 per unit per month. Though it felt like a hit at first, when I was done, the units were gorgeous.
On the surface, I had a 6¼-year payback:
Let’s look at the math: $45,000 in upgrades ÷ $7,200 per year in rent increase = 6.25 years.
At a 3.5% CAP rate, which this particular building is currently valued at, the $7,200 per year rent increase amounted to an increase of more than $205,000 in the building’s worth. Multiply that by 2 (there were two units) and in the end, I spent $90,000 and increased the building’s value by more than $400,000.
If I put the building on the market two days after construction completion and re-rental of the units, the buyer would calculate the NOI based on the new rent roll.
Most first-time buyers are inclined to buy a beautiful property, on the best street, with units that have been recently redone, with all rents at market rates.
What you’re ideally looking for is the ugly duckling building on the prince charming street. You want a building with rents well below market, with plenty of upside when you renovate. If you can replicate a similar situation to what I described above, i.e., spend $45,000 on a renovation to produce a $205,000 increase in the building’s value, and you can do this with a few units, then you’re now in the money.
Do this over and over again, and you’re now on your way to creating wealth.
My sense at this point is that the MUR real estate market in Toronto is trading at CAP rates that are so compressed, it’s harder to make a buck as a long-term buy and hold owner, especially if there’s no upside in the rent rates. Your return will come, if not from improving the units and increasing rents, then from property appreciation.
You have a choice though, which is to buy a property in an area with more attractive CAP rates. Keep this in mind … a property that is viewed to have better appreciation prospects are going to have lower CAP rate assumptions, just as companies with higher growth prospects tend to have higher PE ratios than those with lower growth prospects.
The market says something when there’s a CAP rate discrepancy between areas. The low CAP rate will hopefully provide a higher price appreciation along with better liquidity. When you get the awesome building in a great area with a low CAP rate, you’re going to give up the certainty of income. There’s clearly a trade-off. High CAP will provide better income. Low CAP should provide better price appreciation.
Before you embark on your hunt for your first property, you need to be realistic with your expectations, and make sure they’re in alignment with your long-term wealth creating plans.
For those who are interested in learning how to make money in real estate, I delve into it in much greater detail in my book, The Kickass Entrepreneur’s Guide to Investing. You can download a free copy of it here.
If you don’t want to read the entire book, you can skip to Chapters 3 and 4, and I’ll show you how to make a boatload of money in real estate investments.
My goal is to help entrepreneurs scale their business, improve profits, and, ultimately, create wealth. You can subscribe here.
Want to know more about me and read some of the other interesting small business growth, profit and wealth stories I’ve written.
Here’s an interesting post I wrote: The Top 2 Mistakes I Made When I Started My Business. That Was a Long Time Ago, and Entrepreneurs Are Still Making the Same Mistakes Today
Here’s one of the first articles I wrote: My Journey Post Business Sale as I Sail Into a New Harbour.
Are you a younger entrepreneur? Here’s another interesting article I wrote:
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