The Big, Fat, Cap-Trap

When evaluating commercial real estate investment options don't fall into the "Cap-Trap".

Many new investors and brokers have the wrong idea that cap rates measure return on investment. This misunderstanding can be a big problem and catch investors and brokers-alike in the cap-trap.

Cap rates project a narrowly focused return for the first year of ownership. However, cap rates DO NOT consider annual cash flows or changes in property value. Cap rates DO NOT take into account the impact of leverage, taxes or risk. As we know these factors can have a HUGE impact on the investment analysis.

How then can I get a clearer picture of the return on my investment?

There are two excellent methods for reaching a clearer picture of investment return, (1) Internal Rate of Return (IRR) and (2) the Capital Accumulation Method.

The IRR begins with equity into the investment and adds in the cash flows. If your scenario involves a sale, this amount can be added at end of the hold period. The IRR calculation is performed utilizing these factors and gives you an idea of the return on investment of each dollar invested, while it remained in the investment.

The Capital Accumulation Method goes a step further and helps you by comparing total wealth accumulated. This method accounts for the cash that comes out of the investment and incorporates this cash into a final analysis. This method is, by far one of the best and most comprehensive methods on the planet.

The BEST tools for complete investment analysis can be obtained through the CCIM Institute. These tools allow you to calculate the real juicy stuff mentioned above including impact of leverage, suspended losses, cost recovery and taxable income received from investment properties.

Next time you’re evaluating investment opportunities look beyond the cap rates and don’t get caught in the “Cap-Trap”.