In a high cap-rate environment, NOI helps uncover the hidden value of real estate
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Understanding a property’s performance plays a significant role in determining its true value to an investor
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WHEN IT comes to investing in income-producing real estate, the topic of capitalization rates (or “cap” rates) is unavoidable. Cap rates have steadily increased among most Canadian property types in the high-interest environment of the past few years, particularly in key markets like the Greater Toronto Area, prompting hesitation among real estate investors. However, it’s crucial for financial advisors to understand what cap rates really represent and how they are used in the process of valuing real estate properties.
When determining a property’s value, cap rates are only part of the equation. Another critical part to consider is net operating income (NOI). In simple terms, a rise in cap rates
Equiton makes high-quality private real estate investment accessible to all Canadians so they can build their wealth responsibly. Founded in 2015, it has experienced tremendous growth – its assets under management have surpassed one billion dollars. This growth trajectory is due to the leadership team’s deep understanding of real estate investing. The firm focuses on capitalizing on value-creation opportunities and building the most robust portfolio possible for its investors, partners, and stakeholders.
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KEY PORTFOLIO METRICS FOR THE EQUITON RESIDENTIAL INCOME FUND TRUST (APARTMENT FUND)*:
Revenue gap to market
“It’s critical to understand that cap rates are just one piece of a much larger puzzle. It’s important to take a holistic approach and look to the future”
Jason Roque,
Equiton
can result in a decrease in a property’s value, but only if NOI is held constant. However, NOI is anything but static. In the multi-family space, NOI is driven by dynamic factors such as turnover, occupancy rates, rental increases, and operating efficiencies, which in turn can fluctuate depending on how a property is managed as well as market conditions.
Knowing this, it becomes clear how understanding a property’s overall performance plays a significant role in determining its true value to an investor.
For advisors evaluating a private real estate fund, looking solely at an asset’s cap rate does not necessarily take into consideration other important factors that can affect the investment. Instead, they offer a window into a property’s value at a specific moment in time.
“It’s critical to understand that cap rates are just one piece of a much larger puzzle,” says Jason Roque, CEO of private equity firm Equiton. “It’s important to take a holistic approach and look to the future.”
significant part in an advisor’s due diligence.
“Firms with an active management approach can really stand out in a high cap-rate environment for the value they can unlock,” adds Roque. He notes that Equiton’s in-house property management arm, Equiton Living, enables the firm to build close relationships with residents and find opportunities for strategically improving property values.
Indeed, a focus on NOI and finding methods of improving revenues within a portfolio is a key approach that savvy real estate companies can use to offset the effects of rising cap rates. For example, the cap rate of the Equiton residential income fund trust (apartment fund)’s portfolio increased by 0.50 percent between Q2’22, when cap rates first started expanding across Canada, and Q1’24. However, says Roque, a roughly 20 percent boost to net operating income – driven by portfolio market rent increases, a robust operating margin, and a healthy gap to market – helped the firm grow the fund’s fair value by 5.8 percent within that same period.
“With market foresight, expertise, and a good measure of agility, real estate firms can mitigate the effects of higher cap rates, and even achieve growth in the end,” says Roque. “Looking at companies with a proven track record of performance is key to uncovering value.”
A limitation of cap rates is that they are not sufficient for comparing properties across various categories of real estate. For example, cap rates for multi-family properties will not produce an effective comparison with industrial, commercial, or detached residential properties. Similarly, it is not necessarily accurate to use cap rates within a real estate category for comparison across markets or regions, which may each face their own set of economic, supply, and demand conditions.
Focusing on cap rates alone can cause advisors and investors to overlook opportunities that may offer significant long-term value in the real estate space. They should be certain to consider local market trends, as well as operating margins, rent gap to market, and other items that can offer hints regarding a property's capacity for future growth. When considering a private real estate firm’s portfolio, its governance and management style can also play a
Although cap rates are typically linked to higher interest rates – a headwind for the entire industry – not all property types are equally affected. For example, according to CBRE’s latest Canada Cap Rates and Investment Insights report , multi-family residential cap rates effectively held stable in the first quarter of 2024. Digging beyond the metric reveals that many attribute this sector’s resilience, even in economic downturns, to an increasing demand for housing, as well as rent growth – a record high of eight percent in 2023.
Behind the demand is a significant uptick in population
growth, largely due to immigration. As well, home affordability challenges affecting most of Canada buoy the multi-family sector’s continued growth. According to the Canada Mortgage and Housing Corporation (CMHC), the national average home price could exceed previous records by 2025. With private affordability on a downward trajectory, the agency believes 2024 could be a year of record rental occupancy and rent increases on unit turnover.
In June, the Bank of Canada lowered its key interest rate by 0.25 percent, with many economists predicting further reductions this year. A drop in interest rates can herald a subsequent decline in cap rates, as well as new opportunities to increase NOI. As economic conditions improve, the Canadian multi-family sector continues to present significant opportunities for advisors and real estate investors.
“Taking a long view of real estate investment means committing to a strategy designed to weather challenging conditions. That positions you for sustainable growth when the markets are strong,” says Roque. “We look forward to achieving lasting results in the coming years.”
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Cap rates are one piece of a larger puzzle
The multi-family advantage
Published June 26, 2024
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“Firms with an active management approach can really stand out in a high cap-rate environment for the value they can unlock”
Jason Roque,
Equiton
32.3%
*As at March 31, 2024
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Overall portfolio occupancy
98.7%
Net operating income growth YOY
19.6%
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Copyright © 1996-2024 KM Business Information Canada Ltd.