Economic Notes: Cap Rates Are One Way To Evaluate An Investment
Last month we got a better understanding of how to calculate the capitalization rate or ‘cap rate’ of a potential investment.
Although the cap rate can be one way to evaluate an investment, sometimes less experienced investors put too much focus on it, there are other numbers we look at as well... These are things you can add to your economic notes for your investing success.
One of the most important ones to us is the Cash on Cash Return. This is exactly what it sounds like, how much money do I get back relative to the amount I invested. Here is a formal definition from Wikipedia:
“the ratio of annual before-tax cash flow to the total amount of cash invested”
To calculate your cash on cash return of an investment you divide the annual before tax cash flow of the investment (business, building, etc.) and divide it by the total cash invested to acquire the asset.
For example, if you purchased a $1,000,000 building with a $250,000 down payment and every month the cash flow from the rents, minus expenses, was $5,000 over the course of the year the total cash flow would be $60,000 before taxes.
If we divide the $60,000 cash flow by our out of pocket investment, we get a cash on cash return of 24%.
Remember, when you are calculating the expenses of the investment, to get this number you ARE including any potential mortgage payments.
There are times when the cap rate of an investment may be average, but with the proper financing arrangements in place you can still have a very good cash on cash return.
In one of the examples from one of last month’s articles, we used an example of a single family rental purchase for $240,000 and rented out for $1,700 per month.
After some expenses, the cap rate worked out to 7.7%, which is very good for most major Canadian markets right now.
Now let’s take this a step further and look at our cash on cash return.
In the example, we took into account (made some economic notes on...) some expenses and figured afterwards we would be left with $18,360 in income for the year.
But we still need to subtract our mortgage payments from this amount.
For the purpose of this example we are going to use a 10% down payment.
This would often mean there would be some sort of private funding source available, vendor take back, or other slightly creative financing options.
With that down payment, and today’s low rates, the total mortgage payments for the year would be about $11,000.
If we subtract that from the $18, 360 of net income we had for the year, it leaves us with $7,360.
That represents a 31% cash on cash return in the first year!
So although the cap rate can look only slightly favourable, the actual return on your money can look great.
Yes, we are making some assumptions and there are details missing, but we see this situation often and many investors miss it altogether.
The same principles also work in reverse.
The cap rate can look very appealing, but the actual return on your investment may not interest you.
The most important thing to remember is that it is important to look at all angles when making your decision.
If you were looking for a long term upside on a building purchase, then you may be willing to live with a low cap rate and return until the time comes for the redevelopment of the area, at which time it is likely your investment could jump in value.
Too often investors focus on only one way to evaluate the investment without ever truly gaining an understanding for the real returns.
The key is to understand all the angles and decide how it fits into your portfolio.
Every investor has different preferences in assets they are looking for. Some multi unit owners will always try to get a specific cost per unit, or a specific amount of profit per unit.
While others won’t concern themselves as much with those numbers.
Neither one is right or wrong, as long as you understand what you are choosing to overlook and choosing to focus on.
The one thing that matters most is that you arm yourself with as much understanding about your investment as possible... And make use of your economic notes along the way!
The more you know, the more you grow… Cheesy, but true!
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