When it comes to real estate investing, knowing the numbers is crucial. Two key metrics that often come up in conversations are capitalization rates (cap rates) and cash flow. While they’re often mentioned together, these terms aren’t interchangeable. Both cap rates and cash flow offer valuable insights, but they serve different purposes and help investors evaluate deals from different angles. Understanding how to interpret and use these metrics can have a huge impact on your ability to identify opportunities and make informed decisions.
Cap Rates
The cap rate is a basic but powerful formula that gives you a quick snapshot of how much return a property can generate relative to its purchase price. It’s calculated as:
Net Operating Income (NOI) is the total income generated by the property (including rent and any ancillary income, such as from parking or laundry services) minus all operating expenses (such as property management, taxes, insurance, and maintenance).
Purchase Price is the acquisition cost of the property.
In simple terms, the cap rate tells you the return you can expect from a property, assuming you bought it without any financing (in cash). It’s like the property’s “interest rate” on your investment. The higher the cap rate, the higher your return on investment (ROI) is, based on the income that the property generates after expenses (but before mortgage payments).
Cap rates vary by market and property type. For example, a cap rate in a hot urban area might be lower (4% to 5%) because properties are seen as less risky and are more likely to appreciate. In contrast, properties in smaller or riskier markets might offer higher cap rates (6% to 8%) because they come with more uncertainty or require more work. A high cap rate might look appealing, but it could also indicate the property comes with higher risk, or it’s in an area with less long-term growth potential.
Cash Flow
Cash flow, on the other hand, is about the money you receive as income after all expenses are covered—including mortgage payments. It’s calculated as:
Debt Service is the mortgage or loan payment the investor is responsible for.
Other Capital Expenditures may include major repairs, improvements, or reinvestments into the property.
While the cap rate tells you how profitable a property is relative to its price, cash flow tells you whether a property will generate income each month. Cash flow can vary significantly depending on how you finance the property. Two investors could buy the same property at the same price, but if one of them has a better mortgage deal, that investor would walk away with more cash flow.
Positive cash flow means you’re making money from the property each month after all expenses, while negative cash flow means the property is costing you money to hold. For long-term investment success, positive cash flow is critical because it provides liquidity. It allows you to cover your expenses, reinvest in other opportunities, or simply weather downturns in the market.
Why Cap Rates and Cash Flow Are Important
Both cap rates and cash flow provide critical information, but they tell different stories. Cap rates help investors assess whether a property is a good deal relative to its price. Cash flow, however, is more about the property’s ability to pay you back in real time and keep your investment sustainable.
Cap rates help with long-term planning. A good cap rate suggests a strong return over time, which is especially important for investors looking to build wealth and equity in their properties. It gives a baseline measure of profitability before you consider things like financing or leverage.
Cash flow is about income and growth. A property with healthy cash flow ensures that you’re not just breaking even but actively profiting every month. This is particularly important if you have a mortgage because positive cash flow helps you pay off your debt while maintaining flexibility for unexpected costs.
Comparing Properties
If you’re looking at multiple properties, cap rates are useful for quick comparisons. They let you see which property offers a better return on the surface, but remember to adjust for location, condition, and long-term potential. Just because a property has a higher cap rate doesn’t mean it’s the better investment—it could have hidden risks.
Assessing Risk
Cap rates can also help you gauge risk. A lower cap rate often indicates a more stable property in a prime location, whereas a higher cap rate may suggest the property requires more work or is in a less desirable area. Investors with higher risk tolerance might look for high cap rates, but those focused on stability might prefer lower ones.
Cash Flow and Financing
Cash flow becomes especially important when you’re using financing to buy a property. The terms of your mortgage—interest rates, down payment, and amortization—can dramatically affect your cash flow. Even a property with a relatively low cap rate could still offer good cash flow if the financing terms are favourable.
Investing in Different Markets
Cap rates and cash flow also change depending on market conditions. In a low-interest-rate environment, financing is cheap, so cash flow might look more attractive even if cap rates are low. But in a high-interest-rate environment, higher financing costs will reduce cash flow, making it harder to find deals that cash flow positively. However, during these periods, cap rates may rise as property prices stabilize or drop, providing better long-term returns.
Value-Add Investments
A low cap rate doesn’t necessarily mean the property won’t generate cash flow. Investors often look for opportunities to improve NOI by increasing rents, reducing expenses, or making cost-effective capital improvements to increase demand and value. This strategy, called a value-add approach, can turn a low cap rate property into a high-yield, cash-flowing investment over time.
The Big Picture: Using Both Metrics Together
Ultimately, a successful real estate investor looks at the whole picture. Understanding how cap rates and cash flow interact helps you make sense of what the numbers are really telling you. You’ll be better equipped to evaluate potential deals, avoid overpaying, and focus on investments that meet your financial goals—whether you’re seeking stable monthly income, long-term growth, or a combination of both.
Simeon Papailias is a leading finance expert and influential figure in the industry. Known for his extensive connections and respected insights, Simeon stands out as one of the top professionals in the nation, offering valuable market knowledge and straightforward advice. Beyond his role as a Commercial and Investment Broker, Simeon is a dedicated advocate for the real estate sector and a passionate entrepreneur committed to guiding others toward their goals and purpose.
As part of its response to Canada’s ongoing housing challenges, the federal government has added another 12 new properties to the Canada Public Land Bank,...
As part of its response to Canada’s ongoing housing challenges, the federal government has added another 12 new properties to the Canada Public Land Bank,...
