Cap Rate vs. ROI

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…

Balancing Home Symbol And Percentage

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.”

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:

INCOME:
Rent – $1,450

EXPENSES:
Mortgage – $854.03
Taxes – $119.30
Maintenance – $271.84

The cash flow for the property, believe it or not, is positive!

$1,450 Rent
-$854.03 Mortgage
-$119.30 Taxes
-$271.84 Maintenance Fees
=$204.83

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:

$17,400 Rent
-$1,431.60 Taxes
-$3,262.08 Maintenance
=$12,706.32

$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%.

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:

INCOME:
Rent – $6,950/month, or $83,400 per year

EXPENSES (annual):
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…

17 Comments

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  1. See what you mean says:

    It’s the difference between ROE and ROA. I see what you mean by the ROA not meaning much since most people buy real estate with leverage though.

  2. Lalit says:

    I like numbers and so this was very good. To make sense of cap rate, think of it as max cost of borrowing for the investment. So this is in Corp Finance terms. What this means is for a Cap rate of 2.64%, you will not want to borrow at a rate greater than 2.64% because in pure finance terms, it doesnt make money (in cash flow terms)

    Hope this helps. As for understanding why the 6 plex would sell for that money, then its because the 6 plex expects capital appreciation beyond the rent roll to provide higher rate of return.

  3. Mark says:

    I use Cap rate for the initial comparison, considering all the same interest rates. ROI is dependent on the investors individual income tax level, and how many right offs they’re able to use! Until we know the investors taxation level, ROI is smoke a mirrors and a way to market a property to seem more profitable to me!

    Thanks for the article David!
    Mark

  4. Appraiser says:

    So let’s review, shall we.

    All-time record sales combined with all-time record prices.

    WITH NO END IN SIGHT.

    What do the real estate bears and stock market wonks make of that combo, I wonder?

    Which empty theory shall be conjured up next?

    Let me guess. Oh yeah, I know.

    Need more anecdotal articles about money laundering and mortgage fraud – pronto!

  5. Appraiser says:

    As a real estate investor, I always keep my eye on cap rates as well as ROI. But I’m also very much interested in capital appreciation, oh look – today’s news release from TREB:

    TORONTO, November 5, 2015 – Toronto Real Estate Board President Mark McLean
    announced that Greater Toronto Area REALTORS® reported 8,804 home sales through
    TREB’s MLS® System in October 2015. This is the best result on record for the month of
    October.

    The MLS® Home Price Index (HPI) Composite Benchmark was up by 10.3 per cent year
    over year in October. Over the same period, the average selling price for all home types
    combined was up by 7.3 per cent to $630,876. Price growth continued to be driven by the
    low-rise market segments.

  6. Ralph Cramdown says:

    Can you explain the ROI in the second example? The mortgage gets paid down by $36,279 in the first year, but it takes $56,021 in negative cash flow to do that. How does the ROI become positive if the investor has to pump in more than the principal paydown? How does leverage improve the ROI if the interest on the loan is greater than the cap rate? I don’t understand.

    1. Cedric says:

      +1.. I also don’t follow

    2. condodweller says:

      The difference is interest. The 36k is only principal where the $56k is principal plus the interest. The return is positive because David is using a 1-year return. The second year you’d add the negative cash flow to your downpayment, as negative cash flow is really an additional investment, and recalculate. With negative cash flow, your ROI will trend down unless you can increase your rent to offset the shortfall. This is why real estate investment is tricky today as you require a large down payment and end up with a likely negative cash flow with not much room to increase rent, plus potential interest increases down the road with a possible capital loss in the near term. To further complicate things, the longer you hold on to the property the lower your average ROI will be because you should really include your capital gain in the calculation which will decrease as you have to divide by the increasing number of years.

      Most people only look at today’s number when they do their analysis. You have to project into the future and recalculate your long-term average ROI to really arrive at a realistic number. You also have to make a call on how long you are going to hold on to the unit to estimate returns as all the moving parts will have a significant impact on your ROI. One may come to the conclusion that at today’s prices you’d get a better long term return in the markets with less risk.

      It works the other way too; positive cash flow is essentially a return of capital resulting in a lower downpayment which increases your next year’s ROI. I have a property where my down payment has been reduced to below $10k and my cost base will be 0 in a few years. But that’s only possible because I bought many years ago.

      Hope this helps…

      1. Ralph Cramdown says:

        But in property #1, the positive cash flow was added to the mortgage paydown to come up with the ROI of 17.5%. In #2, even if we ignore the negative cashflow and focus only on the mortgage paydown versus the downpayment, we get $36,279 / $748,500 = 4.9%. I still don’t understand.

        1. condodweller says:

          Ok Ralph, I see what you mean. I took David’s ROI numbers at face value without doing my own calculations. Now that I’m fully awake and ran some numbers I can’t come up with David’s ROI of 13.65% either, therefore I will leave it for him to explain.

          The overall ROI may still be positive in the final analysis since the average return through principal per year is $68000 which still covers the $55000 negative cash flow or new investment. I suspect David switched to the 1.9% rate because he realized at 5% the numbers become very complicated. Using 1.9% it becomes easier as the first year principal return is $55000 which is greater than the cash flow deficit of $22000.

          It all boils down to one’s definition of ROI. I never calculated my return of principle into my equation as I prefer to treat it as part of my capital gains which I divide by the number of years held or plan to hold. I find it much simpler to wrap my brain around it this way. I think of two kinds of ROI, short and long term. Short term is simply my actual positive cash flow after taxes based on my downpayment. Long term ROI or a better description may be final ROI is the short term ROI plus the return of principal and capital gains divided by the number of years held.

          If I calculated my return of principle into my short term ROI, my cost base is already at 0. How would I calculate my returns going forward on a 0 investment?

  7. condodweller says:

    I will take 13.65% of 748k over 17.5% of 51k any day. Just saying. Now where did I put that $748,500.

    I use ROI after taxes based on my own calculations. MLS listing can use whatever, it’s irrelevant to me.

    P.S. Don’t forget about income tax. Especially on the 6 plex.

  8. Joel says:

    The interest payments made on a rental property are also tax deductible, which helps with the numbers.The roughly $3600 paid towards the interest will work out to a few dollars a month made/saved as well.

  9. Gloria says:

    Thank you for this insightful post! I love the debates and how each person sees the situation differently. For an average joe shmo that just wants to build equity, the Liberty Village condo option is definately a low risk investment even if roi is not the best option out there. Anyway, I know who to call when I need real estate expertise. Thank you David!

  10. Noel says:

    I’m not as bullish as you on that Liberty Village condo as you. First of all you can easily apply an average of a 2% vacancy rate to a condo, which is a month vacant in between tenants every 50 months. That brings the rent down $29/mos. Then you’ll probably pay for someone to paint the condo in between and do other repairs which convervatively would be about $1K, which spread over 50 mos is $20/mos. Those together are $49 which brings your $1,450 rent down to $1,401 and the net cash flow to $155.83. Then just a 1/2% increase in the variable rate brings the monthly payment to 904.94 (unless it’s a fixed payment mortgage), which is $50.91 which brings the cash flow to $105 and the amount of the payment contributing the the principal to $502 or $34 less. And I haven’t even gotten to reduction in cash flow due to cash calls from the condo management that the owner has no control over. With property taxes and maintenance fees always increasing that’s not much of a buffer even with rental increases that cannot exceed that allowed.

    Also, you appear to have forgotten to include the LTT in the calculation, unless it was a part of the $255K. If not that’s another $4,575 to be added to the $51K which makes it $55,575.
    With the interest rate increase the return goes down to ($105*12 + $502*12)/$55,575 = 13.1% and that all sounds great but that condo has to increase by about 7.2% in value (assuming the standard 5% commission) for him to break even on the acquisition cost. Sure that will likely happen over the long-term but I am not so sure in the short term given we are at historical low interest rates with no way to go eventually but up and condo supply can be gauged to meet demand.

    I’d rather not have the hassle of dealing with tenants just to make 13% on a $56K investment that has asset risk and liability for condo cash calls but I guess if one can find a whole bunch of these investments and hold them for the very long term it could be attractive to some people.

  11. Marina says:

    Well, ROI is variable depending on the financing terms, so maybe cap rate is simply more straightforward. And like most straightforward numbers, it’s not the most useful.
    I would think most people buying for investment do their own calculations based on their individual goals… I would hope so anyway. Moho would invest based on some agent’s calculation on MLS anyway? For all you know it’s some jacka$$ in the boonies who does one deal per year.

  12. Kyle says:

    Either measure is fine as a rough filter only, but when it comes to actually evaluating a property i would never rely on either of them, especially if they were given to me by the seller’s Realtor. I want a property that more than carries itself and has strong appreciation potential (i.e. positive income and growing equity). IMO, the way to actually figure out whether a property more than carries itself is to come up with a realistic income statement and balance sheet for the potential investment, build in some conservatism and to verify any assumptions against the real world. The way to figure out whether a property has strong price appreciation however is as much art as it is science. Consider things like an area’s population growth, transit, area’s desirability, amenities, risks, are the residents incomes from diversified sectors?, etc.

  13. Noel says:

    David,

    I think you meant to say (omitted word bolded):

    Both are fair questions, and the second one is quite true – the “cap rate” is a number that does NOT 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.

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