5 Things you need to know about cap rates and multiples in valuations

By JT Dhoot

The term cap rate or multiple (or some variation thereof) will sound familiar to anyone who’s tried to value a commercial property or a private business. Stakeholders such as investors, brokers, lenders and appraisers often use these seemingly simple metrics to calculate the market value of an asset. Here are five things you need to know about cap rates and multiples.

The annual cash flow (or some other measure of economic benefit) of an asset can be divided by a cap rate or multiplied by its equivalent multiple. The resulting value will be the same, as shown below.

Value = Annual Cash Flow / Cap Rate = $50,000 / 5.0% = $1,000,000

Value = Annual Cash Flow x Multiple = $50,000 x 20 = $1,000,000

2. Cap rates and multiples are used to convert a single period of economic benefit into value.

The “economic benefit” is typically expressed as an annual amount and although cash flow is preferred, practitioners can also use other metrics such as revenue, earnings before interest and tax (EBIT); earnings before interest, tax, depreciation and amortization (EBITDA); and/or net operating income (NOI), to name a few. In the end, how the cash flow is calculated determines the characteristics of the resulting value (enterprise value, equity value, terminal value). In other words, capitalizing (dividing) or multiplying the annual cash flow of an asset will produce an estimate of value but understanding how that cash flow estimate was derived (before debt vs. after debt, before tax vs. after tax, Year 1 vs. Year 5, TTM actual vs. normalized pro forma) is of critical importance. The cap rate (or multiple) is inseparably linked to the economic benefit to which it is applied, meaning that estimating one in isolation of the other can result in a misleading estimate of value.

3. Cap rates and multiples assume the economic benefit will continue in perpetuity.

Using our earlier example, purchasing an asset for $1,000,000 at a 5 per cent cap rate implies the purchaser will receive $50,000 in the current year and all future years – or does it? Implicit in the cap rate (or multiple) is a growth rate, meaning the investor would expect the $50,000 to grow at a constant rate of x per cent in perpetuity. This is similar to the valuation of a stock using the Gordon Growth Model, also known as the Dividend Growth Model.

4. Cap rates and multiples reflect the perceived risks associated with the underlying cash flow.

All else equal, greater perceived risk means a higher cap rate (lower multiple), which ultimately results in a lower valuation. Let’s look at two potential investment opportunities:

Should you apply the same cap rate (or multiple) to Investment A as Investment B? No, although each investment generates $50,000 in cash flow.  Investment B has more risk even though it has similar growth prospects. In other words, a prudent investor would choose the less risky option (Investment A) over the riskier option (Investment B) if the investor was paying the same price in either situation. Alternatively, the investor would pay less for the risker option (Investment B) by using a higher cap rate in his/her valuation.

5. Cap rates (and multiples) do not distinguish between return ofcapital and return on capital.

Assuming the cap rate used in the acquisition of an asset will equal the investors return on investment is almost always incorrect (more on this in another article). In real life, cash flows and values rarely increase at a constant rate…investors use varying degrees of financial leverage (debt), and taxes can have a material impact on how much cash the investor is left with in his or her pocket at the end of the day.

Summary

Cap rates and multiples are easy to use but as they say, “The devil is in the details”. While some investors focus solely on the cap rate (or multiple) when evaluating investment opportunities, sophisticated investors understand these metrics are only a starting point. Is purchasing a property at a 5 per cent cap rate or acquiring a business at a 4.0x multiple a good deal? As with most things in life, it depends.

Tags: Cap rate,commercial lending, valuations, commercial mortgage

Credit Score TidBit

Here’s a tidbit of info for those that don’t know. Have you ever had a client tell you that their credit score was good because they just pulled it through Equifax’s consumer platform, only to pull a report yourself and see it way lower than your client thought? This is because the consumer is seeing their “Credit score,” and we are seeing their “Beacon score.” Seeing as they likely won’t know what the difference is, here are a few specific differences between the two:

1. The Beacon score is specific to the mortgage industry and the factors there within / The Credit score is more broad and includes predicted habits in all areas of credit.

2. Beacon looks at one’s past 24 months of reporting / Credit looks only 6 months back.

3. Beacon only recognizes a trade line as an influence after 3 months of reporting / Credit recognizes trade lines after first report.

4. Beacon predicts potential delinquency within the next 2yrs / Credit predicts within the next 1yr.

These are the reasons why Credit scores are generally higher than Beacon scores. Consumers can obtain their Beacon score but I believe it is an extra $30 or so. I’m sure we can all remember multiple times a client has said that their score is great, only to hear us tell them it actually isn’t.

Stress Test Causing National Housing Slump: CREA

The Canadian Real Estate Association (CREA) blames the mortgage stress test introduced in January for slow activity across the nation in April.

The housing market has cooled in all respects from April of last year, when the market peaked: the average sale price declined by 11.3 per cent to $495,000, and home sales by 2.9 per cent, reaching the lowest level seen in more than five years.

“The stress test that came into effect this year for homebuyers with more than a 20 per cent down payment continued to cast its shadow over sales activity in April,” said CREA President Barb Sukkau.

All federally regulated lenders must now qualify applicants for their uninsured mortgage at the Bank of Canada’s benchmark rate (currently 5.34%), or their contract rate plus 2 per cent, whichever is higher. This new guideline has priced many out of the market, or forced them into less expensive types of properties.

This becomes apparent when we look at the difference in activity among market segments. Apartment units posted the largest year-over-year price gains at 14.4 per cent, whereas detached homes, typically the most expensive market segment, were down 4.8 per cent.

OSFI, the bank regulator, instituted these new rules in response to overheated markets in the Greater Toronto and Vancouver areas, but its effects are far-reaching, to markets that weren’t considered in need of a cool down in the first place.

Alberta, Saskatchewan and Newfoundland and Labrador were profoundly affected, says CREA, adding to their economic woes of declining natural resource prices. “This is exactly the type of collateral damage that CREA warned the government about,” says Gregory Klump, CREA’s chief economist.

Meanwhile, prices in British Columbia inched up one per cent, driven by high condo sales, and the average selling price remains over $1 million. Toronto has fared worse, with prices down double digits, mostly due to falling sales of detached houses over $2 million. The average selling price is now just under $805,000,

The only markets that saw price gains year-over-year are small cities: Halifax, Montreal and Ottawa.

Bank of Canada Sets Stage for July Rate Increase

STEVE HUEBLMAY 30, 2018
The Bank of Canada once again left interest rates unchanged today but dropped clues suggesting a strong chance of a hike at its next meeting in July.

In today’s announcement, the Bank of Canada noted that inflation has been close to its two per cent target and will likely be higher than forecast in the near term. It also referenced recent data points that show upside to the U.S. economic outlook, weighed by ongoing uncertainty about NAFTA negotiations and stresses in some emerging markets.

“Overall, developments since April further reinforce the governing council’s view that higher interest rates will be warranted to keep inflation near target,” the bank noted in its release. “Governing council will take a gradual approach to policy adjustments, guided by incoming data.”

Observers noted the tone of the BoC’s statement was more hawkish than previous announcements, including its omission of the line “some monetary policy accommodation will still be needed to keep inflation on target” and the word “cautious” in reference to future policy announcements. It also introduced the term “gradual” to describe the approach to policy adjustments.

“The statement was much more hawkish than the market anticipated, especially after the early week global financial market gyrations,” wrote BMO economist Benjamin Reitzes in a research note. “This is a clear warning shot that a July rate hike is a solid possibility.”

The market consensus is that two more hikes are still on the way this year, with BMO predicting those to come in July and October.

“While we may need a grammarian to distinguish between ‘cautious’ and ‘gradual,’ the message was nevertheless clear: get ready for another rate hike,” wrote TD bank senior economist Brian DePratto. “Gone are concerns about potential slack. This reinforces our view that as the economy continues to perform well into the middle of the year, the bank will have the confidence it needs to raise its policy interest rate at its next scheduled decision, this July.”

The rate hold through to at least July is at least a temporary reprieve for existing adjustable-rate mortgage holders who have already seen their monthly payments increase by about $35 per $100,000 of mortgage since the BoC started raising rates last July.

For new homebuyers, however, variable rates are still available at a discount (prime – 1.00%) as part of the big banks’ variable rate war that began earlier this month. However most of those offers, at least officially, will be ending by this Friday and June 4.

Despite steadily rising fixed mortgage rates over the past year, and recent increases to the big banks’ posted rates earlier this month, there are hopeful signs for fixed-rate shoppers that rates are about to pull back a little bit.

On Tuesday the market saw a sharp drop in 5-year fixed bond yields, which fell nearly 30 bps from their 7-year high reached two weeks ago. Since bond yields lead fixed mortgage rates, mortgage hunters are seeing fixed rates dropping slightly this week.

But as mortgage planner David Larock noted in his blog post this week, “To borrow a famous quote about stock prices, fixed mortgage rates tend to take the elevator when they go up and the stairs when they go down.”

The Latest in Mortgage News – House Prices Under the Microscope

STEVE HUEBLMAY 25, 2018
For homebuyers and homeowners alike, all eyes have been on the housing market in recent months waiting to see where house prices are eventually headed.

With house prices already cooling on average across the country, particularly in and around the Greater Toronto Area, some are speculating that the chill in the market could continue well into the second half of the year.

Signs of a Prolonged Housing Slump?
The Canadian Real Estate Association reported that
the average sale price in April declined by 11.3 per cent from its peak a year earlier to $495,000, while home sales were 13.9 per cent.

BMO Chief Economist Doug Porter noted that sales are now down 21.7 per cent in adjusted terms from the record high in December, just before the new mortgage stress test came into effect.

The lower home sales have resulted in a drop in listings, a sign that sellers are waiting for prices to pick up again before selling, according to Porter.

“Notably, the sag in April sales was accompanied by an even bigger pullback in new listings, in a sign that potential sellers are unimpressed with the prices on offer,” he wrote in a recent note.

Meanwhile, during its second-quarter earnings reporting, CIBC says it expects a drop in mortgage originations in the second half of the year due to the mortgage stress test that came into effect January 1.

“We expect there to be an origination decline in the 50 per cent range relative to the same period last year,” Canadian retail banking head Christina Kramer said in a statement.

Average Cost of Government Housing Policy is $113k, Report Says
“Restrictive” government housing policies have driven housing costs up an average of $113,000 across Canada.

That’s according to a recent C.D. Howe Institute report entitled “Through the Roof: The High Cost of Barriers to Building New Housing in Canadian Municipalities.”

The report says barriers to building more single-family housing supply have resulted in homebuyers paying an extra $229,000 per house between 2007 and 2016 in the eight most restrictive cities in Canada. That premium is about $113,000 for a house in the GTA, $113,000 on average across Canada, and a whopping $600,000 for the average house in Vancouver.

“Recent policies—such as taxes on foreign buyers or new federal mortgage rules—have focused on curtailing the demand for housing, instead of taking meaningful steps to increase the supply,” writes co-author Benjamin Dachis, adding that policies such as zoning rules, restrictions on developing agricultural land, and development charges directly influence both new and existing housing prices.

“A well-functioning housing market results in the market price of housing being close to the feasible cost of constructing it,” the report says.

Home Capital secures cheaper credit line from two Canadian banks
In other news, Home Capital announced last week that it had replaced its $2-billion emergency funding facility from Berkshire Hathaway Inc. with a $500-million standby line of credit from two unnamed Canadian banks.

The alternative mortgage lender confirmed the commitment to its subsidiary Home Trust for the two-year secured line of credit.

The terms of the deal stipulate that Home Capital will pay a 0.75-per-cent up-front commitment fee, a 0.6-per-cent annual standby charge on any unused funds and an interest rate on drawn funds equal to the Canadian benchmark rate plus 150 basis points.

Under the previous deal with Warren Buffet’s Berkshire Hathaway, which matures in June, Home Capital is paying Berkshire a 1-per-cent standby fee on the $2-billion credit line and would pay 9-per-cent interest were it to draw funds.

Home Capital CEO Yousry Bissada told shareholders that Home maintains a “very good relationship” with Berkshire. In an interview with the Globe and Mail he added that “Berkshire’s view was [the credit facility] is not their sweet spot, this is not an area of expertise for them.”