Forget CAP Rate!

I have thought about writing a blog post discussing the various methods of analyzing investment properties for a while to help first time and experienced real estate investors. I saw a listing advertising 5.8% CAP rate for a downtown Toronto investment property which got me to look further into the numbers.

Capitalization (CAP) Rate

CAP Rate = Gross Income - Expenses (excluding mortgage financing) / Purchase Price. Here is a list of my personal issues with CAP rate calculation:

  1. Does not tell the whole story: rents might be below market, maintenance has been neglected/deferred by existing owner for years, high tenant turnover, vacancy...It tells me about the past performance of the property not the future
  2. Financing costs not included: It makes a difference if the property is financed at 3% or 5% mortgage

Cash on Cash

Cash on cash is future based indicator. It accounts for:

  1. Amount of cash required to acquire the property (downpayment, closing costs, renovations)
  2. Mortgage financing: cost of borrowing money has a major impact on cash flow projections

My clients have purchased properties with low CAP rates and turned them into great investment properties with a good cash on cash return.

Example: A duplex was rented for $1900 main unit and $750 basement unit, after renovations was turned into $2575 main unit, $1250 basement unit and the tenants paid all utilities.  The cash on cash for the property is 7% using 5% vacancy and 5% repairs & maintenance (Cash on cash is 9% if vacancy and repairs & maintenance are at 1% each).  10% might seem high but it is a number I encourage you to use to build up the reserve funds in case of an emergency.  The reserve fund can be reviewed annually and some of the monies can be used to prepay the mortgage down.

I prefer using cash on cash since it accounts for the amount of capital required for acquisition and provides the expected returns once the property is up and running.

Going back to the investment property listing, 1% vacancy was used and no repairs and maintenance were accounted for.  Yes, 5.8% is too good to be true for a downtown Toronto investment property.

If you are buying your first investment property or have questions regarding your investment portfolio, we would love to help.