The table above is from Green Street Advisors. What it shows is that if all real world expenses including contingencies are not incurred when calculating NOI (net operating income) then assumptions cannot be made confidently about relative market value especially in a flat or declining market. In a rising market, buyers are generally forgiving or asleep because rising market values tend to reach their limits well before the NOI math catches up.
Sellers tend to be bullish in a rising market which is ironic since one would think they would be buying not selling. In a falling or flat market everyone sharpens their pencils.
The CBRE Ltd Brokerage group have released their 3Q 2017 Canadian Cap Rate Survey and they have average cap rates for apartments in the 4-5% range depending if it's an "A" or "B" class unit in a high or low rise building. The higher the cap rate is on a unit, the lower the market value will be relative to its peers.
But the CBRE warns the reader in their glossary of terms that the Cap Rate:
estimates are provided by NIT members in respective markets based on market transactions and/or feedback from investors on their current yield expectations.
Yes - expectations - that's the future - which is fundamentally uncertain.
We can see from the Green Street Advisors table above that capital reserve expenditures are prominent line items if one wants a realistic answer to the question "What is the Cap Rate".
In my 2013 Vancouver Condo Study, I refer to Cap Ex Reserve as "Contingency" which is the term Green Street uses for future expenditure to maintain income at the highest levels. That's the contingency account. Strata Corps are obliged to maintain 30 year depreciation reports, but some strata corporations don't apply all the rules; Caveat Emptor!
See "10 Myths Delaying Depreciation Reports" VISOA.bc.ca
In my model calculations, I also use a percentage of gross income, 5% each for vacancy and management as well as Cap-Ex.
The Green Street model warns its reader that:
Different property sectors have different “standard” cap-ex deductions. All of these standard deductions are far lower than what an owner actually spends, and they are simply helpful to normalize quoted cap rates.
In my model I use a vacancy rate expense of 5% of gross income but in markets like Vancouver, the vacancy rate is less than 1% of the housing stock but on the other hand I use only 5% of gross income for management fees but if you do a survey of managers, they are charging anywhere from 5-10% of gross income.
So when you ask the question, "What is the Cap Rate?" make sure your respondent tells you what expenses have been used in calculating the NOI. If Cap-Ex (contingency), vacancy and management fees are not included in the line item expenses, then put them in regardless of whether you are planning to do your own management, whether the vacancy rate is very low or whether the unit is very new.
If you do the management chores, that's a job and time spent and if the vacancy rate is low, it's not a guarantee that you won't miss a month's rent in a calendar year and if a contingency fund is not accounted for, you might as well be asleep to the fact that real estate is a depreciating item on your balance sheet in physical terms, accounting terms and if the market trend goes from rising to falling then it's depreciating in market value terms as well. That's called risk and the first line of defense is to ask the question, "What if?".
Promoting Your Rental
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July 31, 2021
History, Charts & Curated Readings
"History, real solemn history, I cannot be interested in.... I read it a little as a duty; but it tells me nothing that does not either vex or weary me. The quarrels of popes and kings, with wars and pestilences in every page; the men all so good for nothing, and hardly any women at all - it is very tiresome." Jane Austen spoken by Catherine Morland in 'Northanger Abbey'
"Progress, far from consisting in change, depends on retentiveness. When change is absolute there remains no being to improve and no direction is set for possible improvement; and when experience is not retained, as among savages, infancy is perpetual. Those who cannot remember the past are condemned to repeat it." George Santayana Vol. I, Reason in Common Sense