In real estate investing, cash flow is often looked at as the be-all and end-all of sound financial analysis. I will certainly admit that while more cash flow is better than less, those who look solely at the net income of a property usually leave great opportunities on the table.
Let’s first breakdown what the term “Cap Rate” actually means. From my experience as a mortgage broker and real estate investor, most individuals who throw these words around rarely grasp what the definition can ultimately show you from a financial perspective. The cap rate of a property is simply a relationship between the net operating income and its value or purchase price. For example, a $100,000 property with $10,000 per year in net income would equate to a 10% cap rate. Naturally then, higher cap rates refer to properties with higher cash flows relative to their prices.
That’s good, right? Yes, but it is misleading on many different levels. Let’s go further.
Investors who look at cap rates as the only required criteria fail to acknowledge that there are other important factors in regards to investing in real estate. Cap rates do not factor in appreciation of the property, one of the biggest ways investors can earn profits. Secondly, they do not include any payment of your mortgage balance, another massive criteria when looking at returns on investment. They also do not include other items such as built-in equity (buying properties under value), renovations required, ease of management, future development and change of use and economies of scale.
Let me ask you this – would you prefer owning a $100,000 property that generates $10,000 in net income or a $5,000,000 property that generates $5,000 in net income. The first example has a much higher cap rate of 10% ($10,000 / $100,000 ) compared to 0.1% ($5,000 / $5,000,000) for the second. Despite having a lower cap rate, the higher valued property would generate substantially higher returns in regards to appreciation and equity build up, not to mention other added benefits often seen with large scaled properties.
To clarify, I am not saying cap rates or cash flow should not be considered – of course they should. But deciding to purchase a property solely based on cash flow is the equivalent of buying a car solely based on fuel efficiency. Yes, it’s an important factor but it doesn’t paint the whole picture. I have purchased numerous properties over my career with low cap rates or even negative cap rates (cash losses) because the other areas of returns far outweigh net income constraints. And yes, I have always made money!