While cap rate certainly has its place in comparing two properties together, it doesn’t tell the full financial picture.
Today I received an ad for a multi-family condo unit, one of hundreds I probably get weekly. Most of the time they don’t bother to list the financials and instead leave that as an exercise to the reader. However, today’s aspiring sales person took the time to write up a quick spreadsheet and post it with the ad, so I figured I owed it to them to at least open the email (plus I like spreadsheets).
On first glance things look interesting. 12 units, 2018 build, 10 occupied through 2021, and a $90k net operating income. I mean, who wouldn’t want an extra $90-grand in their pocket each year? Of course, you do have to plop down a cool $1.25M to buy it.
Commercial properties typically use the term “cap rate” as a metric of comparison, as it shows the property’s income-producing ability as a ratio to its cost. Doing the math… $90k/$1.25M works out to a 7.2% cap rate, not bad compared to single-family home (SFH) investments in Austin that are typically around 5%.
But is it a better investment?
Let’s say you have $1.25M in cash sitting around and you decide to buy the building, you’re gonna make 7.2% on that investment… that’s what cap rate means. Keep in mind that your actual return will be lower than this after taxes, but for brevity, let’s just ignore taxes. Now let’s compare that to our trusty spreadsheet for a typical single-family home (SFH) investment. While I don’t calculate cap rate on the spreadsheet (I think it’s too confusing for SFH investors), we can easily get it by dividing the ~$13k Net Operating Income by the ~$255k cost basis… or a little over 5% cap rate. So on the surface, the 7.2% is starting to look like a winner. However, scroll down a bit to the APY for Net Income, and you’ll see an 8.1% return in year one. This metric is an equivalent compare to the 7.2%. So even ignoring the aforementioned taxes, and with a cap rate 2 points lower, we’re actually making almost a point higher return on investment (ROI).
Now, in all fairness, I cheated a little. It isn’t fair to compare a cash-buy to a financed-buy, as you will almost always get a higher ROI leveraging other people’s money. But it serves to illustrate that you can’t just look at cap rate when evaluating investment properties. While cap rate certainly has its place in comparing two properties together, it doesn’t tell the full financial picture. That’s why I always encourage SFH investors to instead focus on the Big Three: Cash flow, Net Income, and Net Investment Income. Together these three tell you how much your bank account will rise/fall, how much you’re effectively making each year, and how much you’ll make down the road once you sell the property.