Commercial Investing

by Darrin DeRoches April 12 - 18, 2012

I have a new client from Toronto that is looking to buy an income property in Hamilton. They have never bought an income property and their main concern is Cap Rate. They want it to be in a good area and be easy to maintain but all they talk about is Cap Rate and ROI. For those who are unfamiliar with these terms Cap Rate is what many real estate investors determine the value of an income property by using the capitalization rate, aka cap rate. It is probably the one most misused concept in real estate in investing. A broker prices a property by taking the Net Operating Income (NOI), dividing it by the sales price, and bing bang boom – there's the cap rate. Example:     Say the property has an NOI of $100,000, and the price is $1,000,000.     $100,000/ $1,000,000 = 10 per cent cap rate     But what does that number tell you? Does it tell you what your return will be if you use financing? No. Does it take into account the different finance terms available to different investors? No. Then just what does it show?     What the cap rate above represents is merely the projected return for one year as if the property were bought with all cash. Not many of us buy property for all cash, so we have to break the deal down, usually by trial and error, to find the cash on cash return on our actual investment using leverage (debt).     So a realistic Cap Rate is around 7 or 8 per cent in our city. This really means very little so we really should be talking about ROI which is Return on Investment. If you are buying a commercial property and the bank requires you to put down 20 per cent then you want to know the ROI on your 20 per cent investment. People who have never invested before believe that if they invest 200 grand in a million dollar property they should make $80,000 dollars a year since there is an 8 per cent return. The reality is the 8 per cent return is on the $200,000 you invested (ROI) which would be $16,000 dollars a year not $80,000. The investor then thinks $16,000 dollars a year is not worth the investment. Wrong!     No other type of investment gives a safe reliable return of 8 per cent or higher.  The bank will give you 1 or 2 per cent the stock market will give you promises of high returns, but then you can lose it all. Real Estate will produce the 8 per cent or better return plus the property itself will value up yearly and it is all relatively safe.     My new clients just keep asking for the highest ROI and think a Cap Rate of 8 per cent is the way to go but there is a lot more involved in just looking at the “real estate jargon” being thrown around. Luckily I have ability to wade through all the bullshit and will be able to find then a safe and reliable investment that will create a great ROI. V     Darrin DeRoches is a local real estate and mortgage broker. He can be reached to answer questions, comments or stories about real estate experiences through this weekly column at mail@uniquerealty.ca.