Can cap rate be compared directly to ROI on other investments?

Question

Hello all,

Newbie here. I'm trying to compare returns on real estate to returns in the stock market and I am wondering if it is fair to compare the cap rate of a fully paid off property to the annual ROI of a particular fund in the market.

If I own a $100,000 property with a cap rate of 10% is this the same as a $100,000 investment in a mutual fund that returns 10% ?

I know it is possible to use my properties equity as a line of credit or to take out additional loans, so what would be a better way to go about comparing the two scenarios.

Paul Moore · Answer

Hi @Trevor J Dammon! You got some great feedback above. This is a really great question and one I had not thought of before. I agree with most of the feedback you got above. You have had a month or two to think about this--what have you concluded?

Account Closed · Answer

I agree with all the above. The IRR is a good way to look at it but you would want to include depreciation, interest payments, cost recovery... I suggest finding a “discounted cash flow analysis” (DCF) template online to determine your IRR.

This will allow you to compare one investment (RE, for example), with another (RE, bonds, mattresses and stuff), as well

Trevor J Dammon · Answer

Hi @Paul Moore,

After more research and listening to the advice of others here I've realized cap rate is a poor comparison to ROI. The initial scenario I laid out (fully paid off property with cap rate of 10%) is a poor premise to begin with, because most real estate investors want to use leverage and therefore won't have a property that is fully paid off with no HELOC. Since cap rate doesn't factor in your initial investment it is hard to compare it to ROI.

Many people suggested looking at IRR for a more direct comparison with ROI. I found that the IRR formula was exceedingly complicated and while I could use a computer to find IRR, I dislike following methods I can't understand. Also, I found it uncommon for IRR to be applied to properties with fewer than 4 units ,which is the size I am examining.

I have my own method for making this comparison which I have found useful and is actually pretty simple. If I want to find the ROI of a duplex over 5 years let's say, first I estimate my equity gained. Houses tend to appreciate 2% per year so over five years the house will appreciate roughly 10%. If the house value was $500,000 when I bought it, it should now be worth about $550,000 and I will have gained $50,000 in equity.  I will also have gained equity due to amortization. Using 5% interest rate over 30 years for this example I will pay off roughly 8% of the loan. Let's say the loan amount was $400,000. After 5 years I have paid off (and gained in equity) $32,000.

What all this math boils down do is after 5 years I will have gained about 16% (varying be the LTV) of the initial property value. To find ROI over 5 years I just have to take 16% of the initial home value divided by my down payment. ($500,000 / $100,000) * .16 = 80% ROI, which is a little better than 12% per year.

Now the big caveat is that all of this assumes neutral cash flow. In other words all expenses even cap ex are covered by rental income and there is no positive cash flow.

You can tweak the loan amount to whatever you feel is realistic for 0 net cash flow. All-in-all it is a pretty simple method but it is useful to get an idea of expected ROI.

David M. · Answer

@Trevor J Dammon

Glad it helped.  Yeah, searching through bp is a pain as its been discussed before.

Basically, its a small "lecture" or read one of the books, and get lots of estimates.  You may start generic, or do it for each prospect.  What is the age of the house, age of the roof, the bathroom, the water heater, the boiler/furnace, septic, sump pump, kitchen appliances, flooring, etc.  One sort of purist would use the IRS depreciation timeline as the life expectancy.  Others would just budget to replace some to most of them at the start or within the first few years so its not a piecemeal headache later on.  Granted, appliances/equipment do sometimes fail early...

some people use a generic percentage to start...  Honestly, you really learn by owning a home.  It can be tough otherwise to get estimates for things when you don't have a home for the contractor to look at.  Granted, many items are home agnostic, e.g. furnace/boiler, appliances, flooring (its just sq ft normally), etc.

The other way to look at it is you will never accurately be able to estimate it.  You can't predict when items will actually fail or just need repair.  Haven't heard from homeowners, much less investors, that there is always some project around the house?  Just realize this isn't a solely investing problem.  Its just the nature of home ownership.

Trevor J Dammon · Answer

Thank you @David M.

It makes a lot of sense. I do love math. So I don't mid tinkering with equations/spreadsheets. Any advice on how I can learn to actually make these estimates?  I have 2% as annual appreciation, but how can I accurately estimate things like maintenance and capEx for 5-10 years?

Again thank you for the thorough response. Much appreciated.

David M. · Answer

@Trevor J Dammon

All as mentioned in this thread..  but let me add that you can try to think of it in that manner.  Just realize its also a bit more "complicatedly devious..."

As with any yield or return, cCap rate is almost synomous with "risk."  One way of valuating commercial property (you arent' supposed to use it with residential, 1-4 family units, but some do..) is via cap rates.  This goes something like if your property rents (I think its usually based off of NOI) are $10k annually and you are saying you have a 5% cap rate, the value is $200k.  If your cap rate is 4%, however, your value is $250k.  The property becomes more valuable because the lower cap rate signifies a "less risky" investment so the value is greater.

In the stock market, a similar situation ocurs.  A security/stock distributes so much in dividend annually.  Divide that by the stock price to get the forward yield.  Theoretically, the market will adjust the price of the stock to correspond with the "riskiness" of the yield.  Some take this further and equate more to a bond which usually has a fixed coupon.  However, cap rate in real estate is somewhat a notional concept, unlike a yield which is driven by, hopefully, a fixed or perhaps increasing distribution.

Does that make any sense?

To answer your last question, you either need to use some sort of existing statistic and realize that its not perfect, or actually work out actual numbers for yourself.  So, its takes a bit of basic math and preferrably a spreadsheet.  You just plug in all the pertinent numbers per prospective deal, or perhaps and actual property, and see what your return looks like.  It all depends on how detailed you want to go with the annual numbers, then if you want to expand into multi-year affects as mentioned above.  You could start basic with rents minus your fixed expenses (e.g. insurance, taxes, hoa if any).  You could include your non-cash deduction of depreciation.  You could factor in appreciation, which is no different for looking at dividend stocks where you factor in both the yield and potential price increase over time...  But your OP mentions loans, so now you are talking about leverage..  Just more math..

So, no short answers.  Clear as mud?  Help at all?  I'd be happy to chat if that helps.  Good luck.

Trevor J Dammon · Answer

Thanks all. I'll continue to do research on the topic.

John M. · Answer

Don't forget that you have a tax advantage of writing off expenses on that investment property such as taxes, insurance etc.  Also you need to factor in depreciation when your calculating your true net.  So even thought the income may be a 10% return on the surface, you will likely pay more taxes on the mutual fund.  Also your heirs get a step up in basis on the property as well which is a tax advantage for them. A good CPA should be able to throw some numbers together based on your tax bracket.

Taylor L. · Answer

In that case then yes, it can, with the caveat that in that case you're not including appreciation. It is not necessarily wise to invest just based on cap rate alone. Always do physical due diligence on the property and know what you're getting into.

Also look into 1031 exchanges, and bear in mind the power of refinancing to access lazy equity.

Trevor J Dammon · Answer

Hi @Taylor L.,

Thanks for your input. Much appreciated.

I meant to say that the property is 100% owned and there is no remaining debt. In which case I think cap rate and cash on cash return are the same if I'm not misunderstanding.  I have started to look at IRR and to me this is the most logical metric to evaluate properties by, however I currently don't have enough of a foundation to make all of the projections required to estimate IRR.

As far as tax implications go I will have to do a bit more research.  I know I can use depreciation to offset some of my gains but beyond that I don't know much.

Can cap rate be compared directly to ROI on other investments?

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