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By Peter Cook and Robert Fleet

In the previous issue, this column began to explain why there is often a difference between lending value and market value. The authors focused on the various sources of revenue and expenses used by lending institutions and CMHC when determining the value of an apartment building and provided several suggestions to help maximize a building's lending value.
 
In this issue, the focus will be on capitalization rates, how they are determined and what makes them vary. There is often a difference between the market cap rate buyers are paying to purchase the property and the cap rate lenders and CMHC are using to determine the value for lending purposes.

Factors that influence cap rates

Capitalization rates are mainly determined by looking at comparable data using existing sales prices of buildings in a particular area. However, this is not the only factor in determining cap rates for lending purposes. Lenders and CMHC also consider risk as an important element for determining the value of a building.

A borrower can expect a relatively high cap rate on a building in need of capital improvements located in a smaller urban center with a struggling economy. Conversely a well-maintained, low vacancy high rise in a larger urban centre will have a lower cap rate.

What makes cap rates vary

Supply and demand will impact whether cap rates will increase or decrease. The greater the demand for apartment buildings, the lower the cap rate and in contrast, the lower the demand the higher the cap rate.

Cap rates will be impacted as returns on other investments such as bonds and stocks fluctuate. For instance, if interest rates on long term Government of Canada bonds increase or stock market returns begin to improve, cap rates will begin to rise as investors look for a risk premium over other investments.

Two views on cap rates

Borrows often have an optimistic and futuristic perception of the building they’re about to purchase while expectation of future property value is not usually taken into consideration by the lender. Although a purchaser may perceive future increases in market value through renovations and higher rents, lenders and CMHC generally don’t consider future value when determining the lending value of your property.

Generally speaking, investors have a more optimistic view of revenue streams and valuation because they are forward looking – they focus on what they will do to improve the operating performance and value of a multi-family property. Whereas, lenders have a more static view of valuation and operating performance – lenders want to establish a hard net operating income to measure mortgage serviceability (debt service coverage) and loan to value.

According to Phil Deschenes of Veritas Valuation Inc., “Often these two viewpoints result in a variance of 25 to 50 basis points between market based cap rates and lending value cap rates.” Phil explains, “It isn’t a matter of lenders and CMHC missing the mark, it’s more a function of employing disciplined and purposeful lending practices driven by reasonably conservative underwriting criteria.”

Clearly market participants - investors, lenders and CMHC all have different vantage points from which they analyze and value multi-family investments. Considering the relative strength of the Canadian lending community in comparison to our American counterparts, perhaps we should be thankful that lenders and CMHC have a moderating effect on the industry. Given the information above, a better understanding of the reasons for the differences between lending value and market value may help mange expectations when the time comes to purchase or refinance a property.

Peter Cook and Robert Fleet are committed to helping borrowers strategize the best loan structure possible. They are available for one-on-one consultation for any CAM reader requiring multi-residential financing. As “Apartment Financing Specialists” with First National Financial LP they have originated over $4 Billion of mortgages. Their combined 35 years experience in the financial industry has lead to frequent speaking engagements across the country. They freely share their knowledge and techniques with audiences, clients and prospective clients. If you have questions, Peter and Robert may be reached by phone or email: Peter Cook at (416) 593-2913 or pcook@firstnational.ca and Robert Fleet at (905) 301-3449 or robert.fleet@firstnational.ca.