Real estate metrics: Cap Rate

I already mentioned Cap Rate in this other post as a comparative metric for Cash-on-Cash.

As a reminder, the formula for the Cap Rate is:

This is another handy metric that allows you to answer the question “How good is this property independent of my financing?”, or putting it in a different way, “What is the return of this property if I paid for it all cash?”.

It is a supporting metric because if I’m trying to compare between two properties, and I know I will only be able to get two different financing schemes for them, the Cash-on-Cash numbers for both might be similar, but the Cap Rate will differ between the two. That’ll allow to take a more “neutral point of view” at evaluation. Cap Rate measures the performance of the property itself, regardless of how the deal is structured.

So, let’s see if I understand this correctly with an example using two properties with the same initial Cash-on-Cash but different Cap Rate:

I am using the French Amortization System to calculate the debt service.

Both properties share the same Cash-on-Cash but wildly different Cap Rate.

• Property A barely yields enough cash (NOI) to cover the annual debt service, but since we have been conservative in our financing, we arrive to a 6% cash-on-cash but a meager 5% cap rate.

  By conservative, I mean we’ve done a down payment of 35% percent of the value of the property, or in another words, the Loan-to-Value is of 65%. I will explain Loan to Value in another post 🪂.

  On top of that we were lucky enough to secure a 2% interest rate, thus lowering the debt service (the mortgage payments basically) and making the cash-on-cash higher.

• Property B was bought with aggressive financing. We only put down 18% of the house price and accepted a 9% interest rate on the mortgage, so our annual debt service is way higher than the one in Property A.

  We did this, because we knew the property was going to be able to be rented for a higher price due to popular demand. Since we put less money down, and the NOI is higher, we should be seeing a better cash-on-cash, but it is damaged by the unfavorable interest rate, hence the 6% similar yield.

  However, provided the NOI is quite high for the same property price comparted to Property A, the cap rate for this one is 9%.

Now we can see that comparatively, both properties look roughly the same when you take only that “dividend-like” yield cash-on-cash. Still, Property B is objectively a better investment, provided that:

• Property A has a thinner income in respect of its debt service, meaning a smaller margin for mistakes (repairs, vacancy, etc..). Any rent decrease or cost increase can even out your cashflow or wipe it out completely.

• Property B has a stronger income and is more resilient to unexpected expenses. Managing to renegotiate a small decrease in the mortgage’s interest rate would have a big positive impact in your cash-on-cash as well.

I guess there is no point of looking at the metrics individually, but finding the balance between a combination of them that matches your expectations. Evaluations must not be done in a void. The kind of mental model it makes sense to have just by looking at these two is:

• Cap Rate: Is this property worth looking into?
• Cash-on-Cash: Will this property meet my periodic income needs, provided I expect a periodic yield and not just a return on the sale?

Have fun!