CAP rates and ROI

[Vikram C.]

I wanted to see how the CAP rate affected the long term rate of return on my investment. I therefore prepared a table that shows the relationship between cap rates, growth in NOI and the ROI of an investment. I am providing the table below in case any of you find it useful.


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The table above is based on pretax earnings. It also assumes a steady growth in earnings and will not be accurate when analyzing an under-managed property that you plan to improve through better management.

The main thing that I have learnt from this table is that it is very difficult to make truly superior returns with investment property unless (a) you buy very cheap, (b) you significantly improve NOI or (c) you use leverage optimally.

For example, if you want to make a 20% return on a property that is already well-run, you will need to buy it at a 17% cap rate assuming 3% growth in NOI. Using leverage brings down the required CAP rate to about 14, which is still high compared to what is easily available to an investor.

One solution would be to use leverage and frequently refinance to keep the interest / NOI ratio relatively stable, but then refinancing is not free of cost.

If my table is not clear, please feel free to ask questions. And please feel free to comment if you have a different perspective.