Knowing how to calculate the rate of return on a rental property is a must for every real estate investor, or at least those who want to make profitable deals. While there are many different ways to calculate return on investment in real estate, the two most popular metrics include the capitalization rate (or cap rate, for short) and the cash on cash return (also known as CoC return). These two measures help investors best decide if an income property poses a good investment opportunity. In these article we will show you how to calculate these measures of profitability and what the major differences between them are.
How to Calculate Cap Rate in Real Estate Investing
Let’s first have a look at the capitalization rate as the easier and more straightforward concept.
What Is Cap Rate in Real Estate?
The capitalization rate is a real estate valuation metric which is usually utilized in commercial real estate investing but also finds a very useful application in residential real estate investments. The cap rate definition states that this is the ratio between the net operating income (NOI) generated by an income-producing real estate asset (as such a rental property) and its sales price or current market value (CMV).
Cap Rate Formula
Cap Rate = Net Operating Income (NOI)/Sale Price x 100%
Cap Rate = Net Operating Income (NOI)/Current Market Value (CMV) x 100%
The annual net operating income formula says that this is the difference between the annual gross rental income produced by an investment property and the annual rental costs. The former is simply the monthly rental income multiplied by 12 in case of investing in traditional rental properties or the product of the average daily rate and the number of days for which a property was rented out in case of vacation home rentals. The latter includes insurance fees, maintenance, HOA fees, management expenses, and many others. The NOI does not take into consideration taxes, interest, depreciation, capital expenditures, and amortization expenses.
The denominator in the cap rate calculation is simply the price which you paid for your income property or its fair market value at the moment.
What Is a Good Cap Rate?
The vast majority of real estate investors and other experts agree that a good cap rate is in the range of 8-12% or a bit more. A new investor might be confused that a higher capitalization rate always marks a better rental property. This is generally true, but up to a limit. The cap rate is essentially a measure of the risk of investing in a particular income-generating real estate asset, and smart investors want to put a limit on the level of risk which they take. After all, one of the most important benefits of real estate compared to other investment strategies is the low risk. That’s why savvy real estate investors should look for traditional and Airbnb for sale properties which promise to generate between 8% and 12%.
To start searching for investment properties for sale with a high cap rate, sign up for Mashvisor today.
Capitalization Rate Pros
This rate of return measure has a few very important advantages:
- Easy to calculate
- Allows for quick and straightforward comparison between the profitability of a few locations and investment properties for sale
- Helps choose the optimal rental strategy for a particular investment property: traditional vs. Airbnb
Capitalization Rate Cons
Unfortunately, nothing in the real estate business is perfect, and neither is the cap rate formula. It comes with the following major drawbacks which real estate investors should take into consideration when conducting rental property analysis:
- Doesn’t factor in the method of financing (cash vs. mortgage loan) in the real estate investment analysis
- Requires extensive investment property analysis
- Disregarded by many residential real estate investors as something limited to commercial real estate
To start making profitable real estate investments in the top housing markets, read our article 2020 Cap Rates by City: What Real Estate Investors Can Expect.
How to Calculate Cash on Cash Return in Real Estate Investments
Now it’s time to have a look at the next metric of rate of return on rental properties.
What Is Cash on Cash Return in Real Estate?
The CoC return is a metric of the rate of return of income-generating real estate assets as the ratio between the cash income and the total cash invested. The cash on cash calculation also defines it as the net operating income (another word for pre-tax cash flow) over the cash investment.
Cash on Cash Return Formula
CoC Return = Pre-Tax Cash Flow/Total Cash Investment x 100%
Similar to the cap rate formula, the cash on cash return calculation looks at the annual traditional or Airbnb income before tax minus the expenses associated with owning and running a rental property.
Unlike the capitalization rate, however, the denominator here is the cash investment rather than the property price. In case of buying rental properties in cash, this calculation is relatively easy as it includes the sale price, home inspection, repair costs, and furniture. If you need to buy an investment property with a mortgage loan, however, things get a bit more complicated. You should not include the entire property price but only the down payment which is usually a minimum of 20% of the sale value for investment properties. Moreover, you need to include the cost of home appraisal and any other closing fees. What this means for real estate investors is that buying income properties with cash and with mortgage yields a very different rate of return.
What Is a Good Cash on Cash Return?
The question “What is a good rate of return in terms of cash on cash?” does not have a definite answer. It depends on the real estate market and the method of financing: cash vs. mortgage. The higher the real estate return on investment in this case, the better. Usually a good cash on cash return falls in the double-digit range.
To start looking for rental properties for sale with a high cash on cash return, sign up for Mashvisor today.
CoC Return Pros
The most considerable benefits of the cash on cash return real estate metric include:
- Considers the method of financing of rental properties: cash vs. mortgage
- A very comprehensive measure of rate of return in real estate investing
- Allows for comparison between the investment potential of multiple real estate markets and rental properties for sale
- Helps investors select the better real estate investment strategy: long term or short term cash flow income properties
CoC Return Cons
When deciding to make use of the cash on cash return calculation in their decisions, real estate investors should keep in mind that it:
- Requires a detailed and even cumbersome real estate data collection process and complicated rental property analysis
- Necessitates the calculation of two scenarios: buying investment properties for sale in cash and with a mortgage loan
To find out the best real estate markets to invest in real estate properties in 2020, read our articles 20 Most Profitable Locations for Traditional Rentals in 2020: Cash on Cash Return and 20 Most Profitable Airbnb Locations in 2020: Cash on Cash Return.
How to Calculate Rate of Return in Real Estate Investment with Software Analysis Tools
As both the cap rate and the cash on cash return are important metrics for making a profitable real estate investing decision, it is recommended that property buyers use both. This further complicates the necessary real estate investment analysis if done manually on a real estate investment spreadsheet.
Fortunately for everyone, this is no longer the case in 2020. Mashvisor has developed an investment property calculator which incorporates both a cap rate calculator and a cash on cash return calculator. This has turned a 3 month research process into 15 minutes.
How Does Mashvisor’s Real Estate Investment Software Platform Help Investors?
The advancement of real estate technology, the introduction of big data, and the application of predictive analytics helps investors in calculating return on investment in two important ways:
- Choosing a Profitable Real Estate Market
Buying positive cash flow properties starts with finding one of the best places to invest in real estate. Conducting real estate market analysis of a few locations requires months, which investors just don’t have at their disposal if they want to move forward with the rental property purchase process before someone snatches all profitable opportunities.
Mashvisor’s real estate investment tools facilitate neighborhood analysis so that investors can select which areas to focus on quickly and efficiently. In specific, Mashvisor’s heatmap tool highlights neighborhoods with high traditional cash on cash return and high Airbnb cash on cash return in any US city or town.
Meanwhile, the rental property calculator shows the average traditional and Airbnb CoC return of any neighborhood market. Moreover, it summarizes whether long term income properties or vacation home rentals generate a higher rate of return in a particular area.
- Finding Lucrative Traditional and Airbnb Rental Properties
Locating the best US housing markets for rental property investing does not guarantee high profitability. That’s why Mashvisor further helps investors by providing them with readily available investment property analysis of hundreds of thousands of rental properties for sale listed on the platform. These include MLS listings, pending listings, foreclosures, bank-owned homes, and short sales as well as some off market properties. Furthermore, real estate investors can add any US property by entering the address to analyze its potential for rate of return. The real estate investment analysis includes both cap rate and cash on cash return estimations as well as property price, financing method, one-time startup costs, rental income, Airbnb occupancy rate, and recurring monthly expenses. As the analysis is provided for both the traditional and the Airbnb rental strategy, Mashvisor’s return on investment calculator helps property buyers choose the optimal approach.
Calculating cap rate and cash on cash return is no longer something which real estate investors need to dread. Mashvisor’s real estate investment software has made finding money-making rental properties possible with a few clicks of the mouse. Sign up for Mashvisor today to start searching for and analyzing top-performing investment properties all across the US housing market.