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Mortgage Interest Role in Cap Rate and Accounting Net Income Calculation

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reinvestors88

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Just for curiosity: why mortgage interest is not being considered when calculating Cap Rate (seen in REIN templates) and not included in accounting net income for many JV presentation we have seen. Are mortgage interest payments considered/reportedly only when filing income tax return? Your feedback is much appreciated.
 
The so called CAP rate CAPitalizes the income stream from an asset into perpetuity.



So if the property income is $80,000 per year and the CAP rate is 8% then the property is worth $1M. You then decide to put a mortgage on the property, or not, or to what loan-to-value (LTV). Some folks like high leverage with a high LTV, with little cash down but little cash-flow. Others prefer a lower LTV with more cash-flow. That leverage does not influence the property value.




CAP rates of course are influenced by a number of factors, such as location, property size, risk, bond rates, demand, stock market volatility, age of asset, unit size, quality of construction, vacancies etc. ...
 
Cap rates are "today" and look at a property before any debt service is taken into account. Does not look at the relationship of time and money. We are currently in a period of low inflation and low interest rates. A very different investment environment compared to the 1990's. One of the reasons today cap rates have dropped today (4-7%) from historic values of 8-14% in my market place.



Institutional investors use other methods that take in the time value of money such as the internal rate of return (IRR) and other means. This type of investor is looking way out, 10-25 years, where the average REIN member is only looking out 3-5 years. And some long term REIN members are looking much further out than they ever thought possible. Creating wealth and preserving wealth have 2 different approaches to purchasing properties.
 
[quote user=reinvestors88]Just for curiosity: why mortgage interest is not being considered when calculating Cap Rate (seen in REIN templates) and not included in accounting net income for many JV presentation we have seen. Are mortgage interest payments considered/reportedly only when filing income tax return? Your feedback is much appreciated.




Hi,



CAP rate measures the property's performance. It is not your real return. If you purchased a property in cash without taking a mortgage and there was no appreciation, then CAP rate would also be the return on your investment.



The nice thing about CAP rate is it allows you an apples to apples comparison between different properties.

if mortgage payments were included in the calculation then CAP would also depend on the different loan to value and interest rates and therefore would no longer reflect only the property's performance but also the different financing conditions 'attached' to different properties. and we dont want that when trying to make an unbiased decision between different properties



One way I like to see CAP is on the DP portion of the purchase price I make 'CAP' (say 7%) and on the other portion - the bank's loan amount which is not even mine:), I make 'CAP-mortgage interest' (say 7%-3%=4%). That's before any price increase. the principle portion of the mortgage payment is an amount you pay yourself, that's why this formula is correct - it does not let it reduce your calculated return/profit. if you look at that simple formula it ignores principle payments. I developed a formula for the REAL return on your investment a few years ago and shared it here.



Regarding net income calculation - this should take into account the mortgage payments (interest+principle of course) because you pay the mortgage first before getting any cash-flow (net income)



For tax purposes the interest is usually a deductable expense. but not the entire mortgage payment because a portion of it goes towards reducing your principle=paying yourself (on paper) which is obviously not deductable.



Regards,

Nir
 
Just a follow up silly question: are there standard Cap rates that we can use to evaluate property performance in a locality, say, Hamilton - McMaster University, Downtown or Mohawk College areas? Thanks a lot again.
 
[quote user=reinvestors88]Just a follow up silly question: are there standard Cap rates that we can use to evaluate property performance in a locality, say, Hamilton - McMaster University, Downtown or Mohawk College areas? Thanks a lot again.


Different areas will have different numbers used as "rules of thumb" but it applies more if you are buying properties that would only be used for investment (ie commercial/industrial/multi-family)



Think of cap rate as a comparison tool. It's one way to compare alternative investments in the same area. (IE this townhouse has cap rate X%, this house has cap rate Y%, this condo has cap rate Z%) They can be used as one way to compare different options.



Regards,



Michael
 
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