One of the questions I get a lot is “whats the cap rate on this one?” Real Estate Investors looking to gauge their return on an investment property like an apartment building will often use the cap rate as a rule of thumb, a quick (but very limited) statement of value.
What is a cap rate? Is it a good indicator for the return you hope to generate on your return? Is there a better figure to look at?
This video takes a look at these questions, so we can better understand some commercial real estate terms
Cap Rate, or capitalization, expresses the ratio between the net operating income a property produces, and the value. It shows up, based on income, what a typical investor (or ‘the market’) is willing to pay for the income the apartment building produces.
Cap rate = Net Operating Income / Price (or value)
When we’re evaluating properties and we want to determine what we’ll pay for a certain apartment building, we will rework the formula to look like this:
Value = Net Operating Income / Market (or desired) Cap Rate
Cap rate does not take into the financing available, so unless you are buying a property in CASH, that is, without a mortgage, you’re going to want to factor in the cost of debt into your return calculations.
That brings us to Cash on Cash return, which is:
Cash Flow Before Taxes / initial investment
We calculate Cash Flow Before Taxes by:
Gross Rent – owner’s operating expenses – mortgage payments = Cash Flow Before Taxes.
Cash on Cash gives you a more precise return, because it accounts for the cost of the debt we use to purchase the property
If you have any questions about commercial and investment real estate in Kitchener Waterloo, Ontario, send me an email to Benjamin AT BenjaminBach.com, call me at 519 772 4376, or @benjaminbach on twitter. I’d love to connect with you!