Real estate investors all know that without return on investment metrics, an investment property analysis says nothing of importance. Investors are also familiar with the dynamic duo of return on investment metrics: the capitalization rate and the cash on cash return. Both metrics tell investors valuable information about real estate investments, namely the potential of the properties for making money. But if a real estate investor had to pick just one of these two metrics, which one should he/she choose? Which real estate metric is better, cap rate or cash on cash return?
To answer that loaded question, we’re going to have to explain the two metrics.
Real Estate Metric #1: Capitalization Rate
The cap rate, short for capitalization rate, is a return on investment (ROI) method that factors in the annual rental income of an investment property and its purchase price (or fair market value). What truly separates capitalization rate from cash on cash return is that the cap rate calculates ROI regardless of how an investment property is financed. In other words, if a real estate property is purchased fully through cash or financed through a mortgage, its cap rate will remain the same. To make more sense of this, let’s move on to how cap rate is calculated.
How to Calculate Capitalization Rate
Here’s how the capitalization rate formula:
Cap Rate = [NOI/Purchase Price (or FMV)] × 100%
The way cap rate relates rental income to the property price is through the net operating income (NOI). NOI is the difference between the annual rental income and the sum of vacancies and operating expenses. Notice how any costs relating to financing are not included.
Cap Rate Example
Concepts are best understood with examples, so let’s use one for cap rate. If an investment property costs (or is worth) $350,000, generates $30,000 in annual rental income, and has a total vacancy and operating expenses of $5,000, what is its cap rate?
Cap Rate = [($30,000 – $5,000)/$350,000] × 100% = 7.14%
What Is a Good Capitalization Rate?
What counts as good cap rate for income properties can vary considerably based on location, asset type, and other factors. Multi-family rental properties, for example, have lower cap rates than single-family properties. Still, experts tend to agree that the general ‘good cap rate’ range is from 8% to 12%.
Real Estate Metric #2: Cash on Cash Return
The second main ROI metric for real estate investments is the cash on cash return, or CoC return for short. Like cap rate, cash on cash return evaluates return on investment of a real estate property based on its rental income. The difference between the two is that the CoC return differs based on the method of financing. Buying an investment property with cash or through a mortgage will yield different cash on cash return results.
How to Calculate Cash on Cash Return
The CoC formula shares some similarities with the cap rate formula. There are, however, significant differences between the two.
Cash on Cash Return = (Annual Pre-Tax Cash Flow/Total Cash Invested) × 100%
What’s glaringly different between the two formulas is that CoC return uses the annual pre-tax cash flow of real estate investments, while the capitalization rate uses the NOI of investment properties. Why does the CoC return have this difference? The answer is so that it can take financing costs into account. Here’s what annual pre-tax cash flow breaks down to:
Annual Pre-Tax Cash Flow = NOI- Debt Service
So, the CoC return considers NOI just as cap rate does, but it also factors in debt service.
The cash on cash return’s denominator also differs from cap rate’s. Instead of the property price, the total cash invested in the property is used. Notice that if a property is purchased fully in cash, the total cash invested is equal to the property price.
Cash on Cash Return Example
If the total cash invested in a property is $250,000, and its annual pre-tax cash flow is $25,000, what is its CoC return?
CoC Return = ($25,000/$250,000) x 100% = 10%
What Is a Good Cash on Cash Return?
Just like cap rate, the range of what is good CoC return for income properties depends on many factors. Overall, though, the general range of 8% to 12% holds true for CoC return as well.
Related: What is a Good Cash on Cash Return?
Cap Rate vs. CoC – Which Is Better?
So, which metric is better when it comes to an investment property analysis? The answer is… it depends. There’s no denying that both the capitalization rate and the cash on cash return are informative return on investment metrics in an investment property analysis. That’s why every good investment property calculator computes both metrics. Nonetheless, there are often situations in which one metric is better than the other.
When Cash on Cash Return Is Better
As we’ve covered previously, the cash on cash return of real estate investments is the exact same thing as cap rate when a property is financed solely through cash. When a mortgage is used, things change. Debt service becomes an important variable, and the total amount of cash invested will not equal the property price. Because the CoC return can be used for the specific amount of cash invested (at a specific time), it is more helpful than the capitalization rate when analyzing the investment property’s ability to make a profit. In other words, cash on cash return is the better return on investment metric to use when determining if an investment property is making money.
When Capitalization Rate Is Better
Since most real estate investors use mortgages to finance the purchase of income properties, you might be wondering why bother with cap rate? After all, the CoC return is essentially the cap rate but modified for mortgage-financed rental properties, so why use it?
CoC return is used to determine if rental properties are making money at a particular time. It’s best used when an investor has a property up and running. However, when a real estate investor is looking for a property, CoC return alone is not the most reliable metric to base the search on. Here’s why.
Cash on cash return depends on a real estate investor’s mortgage terms. The down payment, interest rates, and closing costs can differ from property to property. In this way, cash on cash return is somewhat of a more ‘subjective’ real estate metric. Cap rate does the opposite. Because it does not depend on financing whatsoever, it is more of an ‘objective’ standard, useful when searching for or selling rental properties. Cap rate is useful for determining a property’s profitability, but it is more useful to use in comparing real estate investments to purchase or to sell.
How Both Metrics Can Be Used Simultaneously
Both return on investment metrics are must-haves for any investment property analysis. The best way you can get the most out of each metric is to use Mashvisor’s investment property calculator. The investment property calculator will present the capitalization rate and cash on cash return (which can be adjusted based on investor’s inputs) for rental properties anywhere in the US. To start analyzing your income properties the smart way, start your trial with Mashvisor!