You have a choice of investing in one of two houses: House A will give you a cap rate of 10% and House B will give you a cap rate of 10%, which one would you choose? At the outset, it may seem that the returns on both of these investments are the same. However, they are very different.
House A is an investment that is run by a practicing Muslim, Ahmed. House B is run by your traditional hedge fund manager, Bob. In this example, your return on investment with Ahmed in House A would be greater than your return with Bob in House B.
How is that so? The cap rate, or capitalization rate, is the net operating income divided by the price of the property:
CAP Rate = NOI / Price
If a house is purchased for $100,000 and it gives a net operating income of $10,000, the CAP rate would be 10%. This does not mean that your return on investment will be 10% because the cap rate does not take into consideration the debt service, your financing or mortgage costs.
Since Ahmed does not have a financing cost because he does not deal with interest, his returns on investment will be higher. On the other hand, Bob who is financing the investment will have to deduct the financing expenses before you get your returns- making the returns lower than Ahmed’s. Remember, both will still show the same cap rate of 10%.
Of course, this is not just a Muslim phenomenon, but with anyone that does not involve interest based financing in the investment. Always make sure to get the cash flow details before embarking on an investment.