Is it better to build and sell the property for immediate profit, or build and hold the property for long-term revenue flow?
Who is buying apartments today?
What Determines the Cap Rate?
- Occupancy level and length of stabilization.
- Location. Vancouver has some of the lowest cap rates in the country and Atlantic Canada has some of the highest.
- Construction type. Assuming equal net operating income (NOI), a concrete building should sell for a lower cap rate than a frame building because it lasts longer.
- Rent levels. New construction should be leased at or very near market rental rates. Meaning, the new buyer can’t raise the rents more than normal rental inflation.
- Lower Capital Expenditures. Since the building is brand new, there should be virtually no capital expenditures for ten years and maintenance and repair should be lower when compared to an older building. This positively affects the NOI.
New Apartment Cap Rate
- Is the building sold full, with two years of stable operating history?
- Has the building just been leased up?
- Is the building built and vacant?
- Or is it just a piece of land with a vision?
Better NOI Growth
A critical factor determining a new apartment building’s cap rate is its better NOI growth compared to the growth of its operating expenses. Inflation is a fact of life in North America, and over time a landlord can expect to raise rents (and thus his or her NOI) by a certain percentage each year, depending on market factors, government regulation, and so on. As buildings age, one can expect operating expenses to grow as well. Newer buildings are assumed to have better NOI growth because the older a building is, the more likely its operating expense growth will exceed its NOI growth.
When the operating ratio falls below 50%, the net income grows exponentially if both revenue and expenses inflate at the same rate. This is especially important and accretive in newly constructed buildings where expense ratios are typically below 35%.
Consider an older building where the half of its monthly revenue is eaten up by operating expenses. Year to year, operating expenses are likely to increase by, say, 5%, while the forces that limit rising rents will likely constrain NOI growth to just 3%. If operating expenses and NOI start on an equal footing, and operating expenses grow at 5% and NOI grows at just 3%, very quickly, the dollar value of operating expense growth exceeds the growth in the building’s NOI.
Now consider a newer building where operating expenses take up just 30% of monthly revenue. If operating expenses grow by 5% and NOI growth is constrained to 3%, the dollar value of NOI growth in the first few years increases, since 5% of 30% is lower than 3% of 70%. The chart below illustrates this.
All these factors above need to be taken into consideration when determining the cap rate for a new building. In summary, a fully stabilised concrete building in Vancouver should have the lowest cap rate in the country, and a vacant frame building in rural Atlantic Canada should have the highest cap rate.