The Cap Rate "Bait and Switch" - Don't Fall for It

Nothing better epitomizes the old "Bait and Switch" than the peanuts gang with poor old Charlie Brown running to punt the football being held down by Lucy.  Well, we all know the outcome of that scenario.  Charlie Brown always ends up on his rear. 

Every week I look at dozens of investment properties and it never ceases to amaze me that I still see unbelievable Cap Rates advertised that are WAY above the market norm.  Sometimes you get lucky and find great properties below market value, sometimes the high Cap Rate is inversely proportionate to the condition of the property, but more often than not it is a case of a Cap Rate that has been misrepresented.

While the Cap Rate is a metric that is used by many to determine whether an investment property provides an acceptable rate of return, the problem is that there are no real guidelines for determining a "proper" Cap Rate.  Some will try to make the Cap Rate look more enticing by not including essentials such as maintenance or superintendent wages.

For instance, I recently came across an investment property with an 8% cap rate in Toronto.  This is well above the going rate which is now closer to 5.5%.  I had requested the rent rolls and expenses as I always do when a property peaks my interest.  As a seasoned investor, it didn't take long to figure out that the Cap Rate was not a true reflection of the properties income earning potential.

When looking at the expense statement of a property, make sure that the following items are taken into consideration:

• Heat (Gas / Electric / Oil)
• Hydro
• Water
• Property Taxes
• Insurance
• Maintenance
• Superintendent
• Property Management
• Vacancy Allowance
• Rented Items (eg. Washer / Dryer)
• Lawn Care / Snow Removal
• Waste Removal

All too often I come across properties that do not include one or more of the aforementioned expenses.  In some cases, such as with smaller properties, if you plan to manage them yourself, you can remove expenses such as superitendent and property management.  Again, if it is a smaller property you can likely strike waste removal as well as the city will likely pick up the waste at no charge.  However, on larger properties, you need to ensure that you have taken all of the above expenses into account.  The maintenance expense is routinely left off when determining the Cap Rate, but I have yet to come across a property that has required ZERO maintenance throughout the year.

New investors need to be aware that this is a game this is played quite often.  When you see a Cap Rate advertised that is too good to be true, make sure you request the rent rolls and expenses to ensure that all of the above expenses have been accounted, otherwise, it won't be just Charlie Brown that ends up on his rear.

Knowledge is Power.  Happy Property Hunting!

Author: Paul Kondakos, BA, LL.B, MBA - Professional Real Estate Investor

Comments

[Paul Kondakos]

As a follow up to this article, I recently came across a mixed use property consisting of both a residential and commercial component. The cap rate seemed very appealing until I started to dig down into the numbers. It turns out the listing brokerage had included the HST from the commercial leases. The problem is that HST flows through to the government so they should have either (A) Not included the HST in the gross income or (B) included the HST as an expense as well. Including the HST (and not properly expensing it) misrepresented the cap rate and padded the bottom line by an additional $20,000. On a cap of 5% thats a $400,000 difference in valuation. Always make sure to check your figures when the cap rate looks too good to be true.

[Paul Kondakos]

Here's another example I ran across today from an actual listing on the CLS:

"General Description
Attn Investors! A Very Well Managed Building With All Major Renovations Completed. New Roof 2010 With Transferable Warranty Till 2015, New Toilets 2011, Windows Replaced 2011, 2 X 100 Gal Hot Water Tanks, 19 Hydro Meters, Tenants Pay Own Hydro, Big Lot With 19 Parking Spots, Most Appliances Upgraded, Good Area With Great Tenant Pool. Good Mix With 2 X 1 Bedrooms, 10 X 2 Bedrooms, 6 X 3 Bedroom Units. Fire Inspection Passed Every Six Months. **** EXTRAS **** Exp/Inc Ratio 33% Roi @ 20% Seller Willing To Vtb For Right Buyer. Seller Looking To Retire. Recent Envionmental, Structural All Clean Clean Clean! Amazing Cap Rate At 7.5% Email/Inquire About Our Detail Package For This Property."

After close examination, the "Amazing Cap Rate at 7.5%" is actually closer to a cap rate of 4.6%. What the sales agent fails to mention in the advertisement is that the 7.5% is a "potential" cap rate if you raise the rents and start charging for parking. These are the "deals" that you have to watch out for. This is a clear cut case of misrepresentation.

[Paul Kondakos]

I came across a new listing today where the agent uses a "Gross Cap Rate" to inflate the numbers and make the financials seem better than they are. The "Gross Cap Rate" means absolutely nothing as it doesn't take into account any expenses, and is, in my opinion, meant to mislead novice investors. Always be weary.