Buying an investment property is a big step in the world of real estate. That is why this activity should be tackled very carefully in order to help you achieve success in real estate investing. Before investing in income properties, it is absolutely necessary to conduct comparative market analysis as well as investment property analysis. Comparative market analysis helps you assess the local housing market. Moreover, through the usage of real estate comps, such an analysis helps in establishing how the property of interest stands in the market.
Investment property analysis, on the other hand, presents detailed information about the income properties themselves. Such information is, for example, the computation of real estate metrics such as cap rate and cash on cash return. Cap rate and cash on cash return are extremely useful when the real estate investor is searching for the most profitable investment properties. That is why in this blog we will concentrate on these two metrics. We will review each of them separately, but we will also compare them to one another. Knowing the key components of the analysis is the key towards making money in real estate.
#1 What Is Cap Rate?
Let’s begin by exploring what is cap rate as a measurement of return on investment. Cap rate is the rate of return on a rental property estimated on the basis of the income the property is expected to generate. Cap rate is broadly used by successful real estate investors, as it estimates their potential return when investing in a property. Interested to learn more about cap rate? Make sure to read “How Can You Assure Good Cap Rate for Rental Properties?”
Logically come the questions: “How can you know when the cap rate indicates that the specific rental property is a good investment opportunity? What is good cap rate?” To be honest, it is hard to indicate what is good cap rate per se. The reason for this is that there is no specific value you should strive for. A good cap rate varies per market. That is why our advice is to research the median cap rate value in the local housing market and aim for that at first.
#2 What Is Cash on Cash Return?
So, what is cash on cash return? Cash on cash return is another measurement of return on investment, as you can probably guess. Cash on cash return presents the return on an investment property based on the cash which was invested in the property. This is done by computing the cash income which was generated in ratio to the cash which was put into the property. Curious to learn more about cash on cash return? Make sure to read “Cash on Cash Return: How Should You Use It to Make the Best Real Estate Investment Decisions?”
Of course, we also need to ask: “What is good cash on cash return?” Once again, there is no single value measuring what is good cash on cash return. However, many real estate investors consider that a value between 8% and 12% is a good cash on cash return. Other real estate investors do not even bother investing in a property if the cash on cash return is below 20%. Nonetheless, successful real estate investors know that such values are nearly impossible to reach in real life. This is due to the fact that the market is very fast-moving and is influenced by a series of conditions. That is why a cash on cash return of 3%- 4% is actually an indicator of an investment property with a real potential for success.
#3 How to Calculate Cap Rate
Sure enough, we also need to discuss the more practical side of these real estate metrics. Actually, the cap rate formula is pretty simple. It goes as follows:
Cap Rate= Net Operating Income/ Current Market Value of the Property
By filling in the cap rate formula, you can simply compute the value. Let’s see how that happens. Imagine that you plan on buying an investment property which is expected to generate an income of $75,000. Also, imagine that the current market value of the property is $150,000. Therefore:
Cap Rate= $75,000/ $150,000
Cap Rate= 0.5= 5%
However, if you want to learn what is the most efficient way of calculating cap rate, make sure to read “How to Calculate Cap Rate for Rental Properties Most Efficiently.”
#4 How to Calculate Cash on Cash Return
The cash on cash return formula is also not difficult to use.
Cash on Cash Return= Net Operating Income/ Total Cash Investment
Let’s also see an example using the cash on cash return formula and computing the value. Again, the NOI would be $75,000. The total cash investment is everything you have paid in cash for the property (down payment, closing costs, etc.) which for this example is $100,000. Hence:
Cash on Cash Return= $75,000/ $100,000
Cash on Cash Return= 0.75= 7.5%
It is important to note that in the case of an all-cash investment- if the whole property is purchased in cash, the value of cash on cash return for that property will equal the value of cap rate for the same investment.
Additionally, even though the formulas for the two metrics are quite simple, when it comes to finding the most profitable investment properties, calculating the values gets complicated. This is because you need to compute the values for numerous properties and compare them. In this case, you can use the investment property calculator, also known as the rental property calculator. Mashvisor’s investment property calculator will compute all the values you need within seconds. Moreover, our rental property calculator has other functions which will help you achieve success in real estate investing with no effort.
#5 Cap Rate vs. Cash on Cash Return
So far, we have established the similarities between the two real estate metrics. Yet, there are some differences as well. For instance, cap rate does not take into consideration the annual investment value, such as mortgage or interest rate, which cash on cash return does. Besides, if the property has not been purchased fully in cash, the value of the two metrics will differentiate. The main difference, however, is the fact that cap rate computes return on the basis of the market value of a property or the full price of the property. Cash on cash return, on the other hand, does so by including only how much you actually pay in cash, which usually isn’t the full price initially.
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