If you’re one of the people that doesn’t like my “financial” or “numbers” blogs, then this certainly won’t be one for you!
But this post has been a long time coming. There’s a massive discrepancy, and to be honest – a misunderstanding, as to how we should evaluate investment properties, whether you’re looking at a small 1-bed condo, or a 5-unit walk-up.
Let’s go through an example of “Cap Rate” vs. “Return on Investment,” and then debate as to which one should be the primary measure of an investment property’s worth…
I’ve been meaning to write this post for quite some time now, only I’ve been dreading it because I know the time commitment required.
Then just last week, a friend of mine showed me an MLS listing for a multi-unit property in Kingston, Ontario, where the listing agent was advertising a whopping 10.8% cap rate.
I couldn’t believe my eyes!
Here in Toronto, prevailing cap rates for multi-unit properties are below 5%, and some might suggest the average is closer to 4%.
I might have thought you could get 7% in Kingston, but what do I know about Kingston?
10.8%? That’s insane!
Then I started to look into the numbers, and I realized that this property did NOT have a 10.8% cap rate.
It had a 10.8% return on investment for the first year.
The cap rate, if you can believe it, was about 5.3%, and I wondered why the hell anybody would buy in Kingston, Ontario with a 5.3% cap rate when they can get pretty close to that right here in T-Dot.
Just because I couldn’t leave it alone, I emailed the listing agent to ask a couple questions, and say, “You have mixed up ROI and cap rate,” and he emailed me back and said, “Same, Same.”
That’s what they print on t-shirts in Thailand.
It’s not a good excuse for a catastrophic misrepresentation of a property’s financials.
The cap rate for a property is simple – it’s the net operating income as a percentage of the purchase price.
So the rent, minus the expenses, as a percentage of the amount paid for the property.
The return on investment is something entirely different, as it takes into account how much money you’ve put into the property, instead of the price paid, as well as the overall return – ie. mortgage principal paid.
In the end, both of these metrics – cap rates and ROI’s, are used to evaluate a potential property’s worthiness. But there is an ongoing debate about which should take priority.
Now just to add a bit more fuel to the fire, let’s also consider cash flow and how positive versus negative cash flow should be looked at, either in tandem with ROI and cap rates, or on its own.
I know that many of you reading this are leagues ahead when it comes to detailed financial analysis, but I want to simplify things here, for both the purposes of this conversation, as well as the examples below.
So let’s take a look at two properties: one condo, and one multi-plex.
I’m going to use a real example of what one of my clients purchased this past summer.
The condo is a unit in Liberty Village – a 500 square foot, 1-bed, 1-bath, with a locker, and no parking.
We bought the unit for $255,000.
For the purpose of all these examples, we’ll assume the buyer puts down 20%, since that’s the minimum down payment required for any second property.
So the $204,000 mortgage carried, at a 1.9% variable rate, for $854.03 per month.
The taxes were $1,431.56 per year, and the maintenance fees were $271.84, plus hydro, but the tenant paid the hydro.
The rent was a whopping $1,450 per month, which was what made this property so attractive.
So let’s set out our numbers:
Rent – $1,450
Mortgage – $854.03
Taxes – $119.30
Maintenance – $271.84
The cash flow for the property, believe it or not, is positive!
-$271.84 Maintenance Fees
So every month, you’re putting money back into your pocket. It’s not rocket science. It’s like running any business – you run a store, and you hope that your sales exceed the sum of your rent, electricity, and cost of the goods that you sell.
It’s very rare for a condo to be cash-flow positive to that extent, but that’s why we bought the unit in the first place.
The cap rate for the property is the annual net operating income as a percentage of the purchase price. We look at cash flow as a monthly, but the other metrics are yearly:
$12,706.32 / $255,000 = 4.98%
As for the return on investment, consider what your “investment” actually is.
It’s the money you put into the purchase, ie. your down payment, which is $51,000.
And your “return” is not just your positive cash flow – it’s also the money that’s coming back to you in the form of equity via the mortgage.
Consider that of the $854.03 per month mortgage payment, an average of $536.94 per month, in the first 12 months, is coming “back” to the investor in the form of principal repayment on the mortgage. Only $317.09, on average in the first 12 months, is mortgage interest.
So another $6,443.28 worth of equity is in the investor’s pocket, and along with the $2,457.96 in positive cash flow, that’s $8,901.24 in total equity.
The investor made a down payment of $51,000.
So the year-one return on investment for the property is $8,901.24 divided by $51,000, or a whopping 17.5%.
Isn’t that, um, kind of a good return?
So compare and contrast that 17.5% ROI with the 4.98% cap rate, and decide which figure is more helpful.
You might ask, “Why are you only looking at year one for the return on investment? This could be a 15-year buy-and-hold.”
You might also ask, “Why are you using ‘cap rate’ when that’s better suited as a metric when you’re buying a property in cash.”
Both are fair questions, and the second one is quite true – the “cap rate” is a number that does take mortgage financing into consideration, and perhaps that’s because it truly is best suited for a property without any leverage. If that’s the case, then ROI wins out. But we only ever see “cap rate” used on MLS listings.
Now I will point out, before somebody else does, that we have ignored acquisition costs (land transfer tax, legal fees), and potential vacancies and repairs, but I’m looking for a very simple, very apples-to-apples, year one look at the property. Over a 20-year period, the couple thousand in acquisition costs will seem insignificant.
Now let’s look at something totally different – a $2,495,000 income property.
This is a massive property, in a very popular area, and I’m sure every one of us would love to own this thing!
There are six units, with rents totaling $6,950 per month.
At $2,495,000, the same “20% down” does not apply, since it works on a sliding scale once you get over $1,000,000. The buyer here would likely have to put down approximately 30%, or $748,500.
But the real difference here is that a 6-unit property is considered commercial, and commercial interest rates will run anywhere from 4% to 6.5%.
So the $1,746,500 mortgage, at, say, 5.0%, will carry for $10,157.73.
So let’s set out our numbers here:
Rent – $6,950/month, or $83,400 per year
Mortgage – $121,892.76 per year ($10,157.73 per month)
Gas – $4,509.36
Hydro – $1,190.66
Water – $2,318.52
Taxes – $6,789.69
Insurance – $2,721.60
I’ll save you the calculations, but the numbers are as follows:
Monthly cash flow: -($4,668.45)
Cap Rate: 2.64%
ROI (Year One): 13.65%
So what conclusions can we draw here?
For starters, don’t let that negative monthly cash flow scare you. Yes, it’s a big amount – almost $5K, but we’re looking at a $2.5 Million property, and not a $255,000 condo.
Second, the cap rate is awful. I have absolutely no idea why somebody would buy a property in Toronto with a 2.65% cap rate in Toronto, but that’s a topic for another day.
Third, the ROI is, relative to the 1-bedroom condo, not that bad. 17.5% for the condo and 13.65% for the 6-plex. But the cap rates are 4.98% and 2.64% respectively.
So while the cap rate of the 1-bedroom condo is 88% larger than that of the 6-plex, the ROI is only 24% larger.
Do you feel like there should be some sort of correlation?
Or perhaps there’s just many ways to skin a cat?
What’s interesting about the 6-plex, is if commercial rates didn’t apply, (ie. if this was just a four-plex), then this would be a far more attractive investment.
Let’s run this example at the same 1.9% variable rate mortgage that we used for the 1-bedroom condo, just for argument’s sake, but keep the rents and expenses the same. This isn’t unrealistic, but rather we’re going to assume instead of 6-units renting for $6,950 per month, there were 4-units renting for $6,950 per month, and maybe they were just better, or in a nicer area.
The $1,746,500 mortgage would only carry for $7,311.57 per month, rather than $10,157.73.
The monthly cash flow is now only –($1,822.39).
The first year ROI goes up to 16.17%.
You’re paying a lower mortgage each month, so you have more cash flow.
And you’re getting more back in the form of principal each month, so have more equity, and thus a higher ROI.
I think the moral of the story here is that if you can get a four-plex instead of a six-plex, then do it!
But I also have to go back to the “Cap Rate vs. ROI” debate, and try and solve it once and for all.
The reason I chose to re-run the numbers with the 6-plex, if it were a 4-plex and thus qualified for a residential interest rate rather than a commercial rate, was to, among other things, show that the cap rate doesn’t change!
So what good is a cap rate then?
Why bother using it if something as irrelevant as the damn rate of interest on financing doesn’t affect it?
You can see where I stand on this debate.
I don’t understand why “Cap Rate” is the prevailing metric in the industry, when it ignores financing, and very few people buy in cash. If the entire buyer pool were buying up properties with cash, then that’s another story.
But I were to list a multi-unit property for sale today, I would market the ROI, and not the cap rate.
I suppose it also depends on what you’re buying. For an investor looking at a 1-bedroom condo, the cap rate is an easy way to look at one condo, versus the next, versus the next, and the financing is always going to be the same.
Well, maybe next time we should have a conversation about why somebody would buy a 6-plex with a 2.64% cap rate…