Cash on cash return and cap rate are two very important terms in the real estate investing business. Essentially, they are real estate metrics used by real estate investors to calculate the return on investment (ROI) for an investment property. However, each metric measures different types of investments in real estate. Before diving into the difference between cash on cash return and cap rate, we first need to understand a few points about return on investment (ROI).
What Is Return on Investment?
Return on investment, or ROI, is a profitability ratio that investors use to evaluate how well an investment is performing and compare the performance of different investments of all types and sizes. It is a common, widespread metric due to its simplicity and broad usage; the metric can be applied to anything from real estate, through stocks and employees, to even a sheep farm – anything, which has a cost with the potential to derive gains from, can have a return on investment assigned to it. However, ROI is very general and includes lots of assumptions and unproven numbers. For this reason, real estate investors opt for calculating cash on cash return and cap care, as they are the most accurate measures.
The capitalization rate (or cap rate, for short) is a measure of profitability used to estimate the real estate investor’s potential profit from his/her investment property by relating the sale price of the investment property to the rental income which the rental property is expected to generate.
Cap Rate Formula
The cap rate of an investment property can be calculated by dividing the net operating income (NOI) of the investment property by the purchase price of the property (its current market value), where NOI equals the annual return on the rental property minus all operating costs. The formula used by a cap rate calculator is as follows:
Cap Rate = Net Operating Income/Current Market Value
Let’s take an example: If a real estate investor buys a property for $1,000,000 and expects that the property will generate $150,000 per year, the capitalization rate of this investment is:
Cap Rate = $150,000/$1,000,000 = 0.15 = 15%
This means that every year, this real estate investor is earning 15% of his/her real estate property’s value as profit. There is no specific range in which the good cap rate falls. However, many real estate experts agree that a good cap rate is usually around 10%, and a great one is 12% or more.
Uses of Cap Rate
1. Real Estate Investment Property Analysis
Typically, it’s assumed that the higher the cap rate, the higher the possible profitability. Nonetheless, with increasing cap rate, the risk of investing in the rental property also increases and vice versa – the lower the cap rate, the lower the risk, but also the lower the possible profitability.
This makes cap rate useful in measuring how risky a real estate investment, which in turn helps real estate investors compare different investment properties, and accordingly, determine whether investing in a certain rental property is worthwhile or not.
2. Comparing Different Real Estate Investment Properties
Comparing different real estate investments based on the operating income or market value can be challenging and can yield complicated numbers. On the other hand, comparing percentages is very straightforward. Cap rate is a comparative real estate profitability metric used to compare against very similar properties – that is, investment properties with a similar location, similar property type, and valued at the same point in time. When determining which properties are good investments and which aren’t, many real estate investors set a minimum cap rate percentage which they will accept and believe will make the investment worth their while.
3. Checking the Performance of Your Real Estate Investment
In addition to the above, cap rate can be used to check how an investment property is doing over a period of time to see whether or not it is improving. If the cap rate of your investment property is increasing, it means that your investment is performing well. The opposite holds true: if the cap rate is declining, it’s probably time for you to reconsider your real estate investment.
Wrapping up Cap Rate
As mentioned earlier, the capitalization rate is a profitability measure that takes into account the price of the property and the rental income which the rental property is expected to generate. Calculating it is quite simple, and it is very useful for real estate investors. However, how do we measure the return on investment for a property which you didn’t buy all in cash, but rather with a down payment and a mortgage? Here is where cash on cash return comes into the picture.
Cash on Cash Return
Cash on cash return, or CoC, is another real estate metric which calculates ROI, yet this metric is different from the previous as CoC relates the cash income earned to the cash invested in a real estate property. To further explain, let’s take an example. When purchasing a rental property, a real estate investor might put down 20% as a down payment. In this case, cash on cash return measures the annual return the investment makes in relation to the down payment only.
Cash on Cash Return Formula
As we’ve said, cash on cash return is the return on the money we actually invest. Thus, the formula used by a cash on cash return calculator is as follows:
CoC Return = Annual Net Operating Income/Total Cash Investment (or Down Payment)
For example, suppose a real estate investor’s annual NOI for the rental property was $15,000, and that the investor had put down $60,000 as a down payment. Then, the cash on cash return would be:
CoC Return = $15,000/$60,000 = 0.25 = 25%
Experts disagree on what is considered a good cash on cash return. Some say that anything in the range 8%-12% is good, while others would not even bother thinking about an investment property if it doesn’t promise them cash on cash return of 20%.
Uses of Cash on Cash Return
- Cash on cash return is generally used to measure and evaluate commercial real estate investment’s long-term performance.
- Similar to cap rate, cash on cash return is also a great way for business owners and investors to run an investment property analysis to evaluate whether their investment will be profitable or not.
- Additionally, cash on cash return also allows for a comparison between different investments. It can compare a rental property to lending, investing in stocks, or bonds, and even starting a business.
Wrapping up Cash on Cash Return
As we can see, when calculating cash on cash return, we relate the rental income to the amount of actual cash invested in the real estate investment property. This is the main difference between the two real estate metrics – financing costs, such as mortgage cost, are included as an expense when calculating cash on cash return, but they are not included in the calculation of cap rate.
Conclusion: Cap Rate versus Cash on Cash Return
When it comes to determining the return on investment, there are two widely used real estate metrics: the cap rate, used to tell you how much profit you’d generate from an investment property if you paid all cash for it, and the cash on cash return, which tells you how much you’d make based on the actual cash invested. Each one has different uses and both help in real estate market analysis and comparison, for the main purpose of helping real estate investors determine the best property for investment.
Be sure to check out Mashvisor’s investment analytics and its investment property calculator, which will help you in conducting real estate market analysis and in all your calculations! Remember that Mashvisor’s investment property calculator works as both a cap rate calculator and a cash on cash return calculator.