This week, a client asked about CAP rates for revenue properties (multiplexes) in Montreal:
Q. I recently moved from Toronto to Montreal and have decided to purchase a rental investment property. What is considered a “good” CAP rate for an investment property in Montreal?
A: CAP rate is one of the first metrics a real estate investor will look at when determining the potential of an investment property.
First of all, what does CAP rate mean?
Capitalization rate, or CAP rate, is the rate of return on a revenue property (generally multiplexes with more than 5 units) based on historic earnings. CAP rate is used to determine current and past revenue generated from a revenue property, and to estimate potential returns on a real estate investment.
The capitalization rate of an investment can be calculated by dividing the investment’s net operating income (NOI) by the current market value of the property determined by using a Compartive Market Analysis (CMA), where NOI is the annual return on the property minus all operating costs. The formula for calculating CAP rate is expressed as:
Capitalization Rate (Cap rate) = Net Operating Income (NOI) / Current Market Value
- Low cap rate: Although most people associate low cap rate with a bad investment, this isn’t always the case. Low cap rates can be a result of poor management in the past, or may indicate that the building needs renovation work to reach its full financial potential. Investors should therefore consider existing cap rate as well as potential/projected cap rate.
- High cap rate: A building with a high existing cap rate is already generating healthy income in respect to its market value. Buying into a building with a high cap rate ensures a healthy return son your investment, without a huge amount of renovation work.
Now, let’s look at average CAP rates in Montreal:
According to Cushman & Wakefield‘s latest CAP rate report (Q4 2017):
- HIGH RISE multiplexes (apartment buildings greater than 4 storeys in height or having more than 80 units) recorded cap rates ranging from 4.25% – 5.25%. 5.25% would be considered a good CAP rate for a high rise building in Montreal.
- LOW RISE multiplexes (apartment complexes having fewer than 80 units) recorded cap rates ranging from 5.00% – 6.00%. 6% would be considered a good CAP rate for a high rise building in Montreal.
These figures are on par with CBRE’s CAP rate statistics for the fourth quarter of 2017:
- High Rise A 4.00% – 4.75%
- High Rise B 4.50% – 5.00%
- Low Rise A 4.50% – 5.00%
- Low Rise B 5.50% – 6.50%
As previously mentioned, a thorough financial analysis takes into account projected CAP rate as well as existing CAP rate.
To project potential CAP rate, an investor should take into account:
Location and average rental rates
Location is key when buying a rental property, because location drives demand.
Research average rental rates in the building’s borough and on the building’s street, by looking at rental market reports or by consulting with your real estate broker.
If existing rental rates fall short of average rental rates in the area, you will want to investigate further and find out why. Does the building or the apartment units need work? How much will renovation cost? Has the building been poorly managed in the past?
Answering these questions will help you understand how much “upside” the building offers, and what your potential CAP rate could be.