Knowing what is cash on cash return vs cap rate calculations and definitions in real estate investing is one of the major basics every real estate investor should be aware of. Real estate investing requires you to deal with different numbers and calculations in an attempt to predict the profitability of a certain real estate property or investment. Cash on cash return and cap rate are undoubtedly the most important terms in this regard.
This blog intends to take you through a small and simple journey to understand cash on cash return vs cap rate in real estate and the differences between them.
Cash on Cash Return vs Cap Rate: Definitions
Looking at the definitions of cash on cash return vs cap rate in real estate, they are closely related. So much so that some aspiring investors may confuse these two terms. Cash on cash return is simply a rate that is often used in real estate transactions to calculate the cash income earned on the cash invested in a certain property. This term is actually one of the most important return on investment calculations in real estate as it helps you estimate the profitability of a certain investment.
On the other hand, cap rate also known as capitalization rate is, in the simplest of terms, the rate of return on an investment property based on the income the property is expected to generate. This calculation or metric is used in order to estimate the real estate investor’s potential return on investment depending on the price of the investment property.
Cash on Cash Return vs Cap Rate: Breaking the Terms Down
Cash on cash return provides investors and business owners with an analysis of the potential or expected cash return over the lifecycle of the investment. Cash on cash return is normally used for investment properties that involve long-term debt borrowing. Keep in mind that the actual cash return on an investment differs from the standard return on investment (ROI) when debt is included in a real estate transaction. This is due to the fact that calculations based on standard return on investment take into consideration the total return on investment. On the other hand, cash on cash return merely measures the return on the actual cash invested. This, in all cases, provides a more accurate analysis of the expected performance of a certain investment.
On the other hand, the cap rate is a great tool when it is used to compare similar real estate investment properties. Therefore, the cap rate helps investors to narrow down choices of different properties to help them determine the best investments to pursue. Furthermore, cap rate will guide you towards purchasing properties with a price that is suitable to the financial outcomes that a certain property achieves.
Cash on Cash Return vs Cap Rate: How to Do the Math
After knowing the definition of cash on cash return vs cap rate, the time has come for you to know how to calculate them. Cash on cash return in real estate measures the annual return a real estate investor makes out of his/her investment in relation to the down payment and any initial costs. The cash on cash return equation is as follows:
Cash on Cash Return = Annual Dollar Income/ Total Dollar Investment
Example:
Let us assume that a real estate investor purchases a property that is worth $100,000 (its total price) and puts $20,000 as a down payment and also $10,000 for closing costs. The investor so far has put $30,000 into the project. Now the total cost of this deal is $30,000 and let’s assume there is a cash flow of $15,000 after mortgage payments and rental expenses.
In this case, the investor has put $30,000 cash into this investment ($20,000 down payment + $10,000 closing costs). Based on the above-mentioned equation, the cash on cash return will be as follows:
Cash on cash return = ($15,000 / $30,000)*100% = 50%
For more information about what is a good cash on cash return, make sure to check out What Is a Good Cash on Cash Return?
The capitalization rate of a real estate investment can be calculated by dividing the property’s net operating income (NOI) by the current market value. The equation becomes as follows:
Cap Rate = Net Operating Income / Current Market Value
Net operating income is a calculation used to analyze real estate investments that actually generate income. NOI is the outcome of all revenue from a certain property minus all necessary operating expenses. Market value is, on the other hand, the price an investment property would fetch in the real estate market. You can find this using real estate comps.
Example:
Let us say that you want to purchase an investment property for $900,000 and expect that it will produce about $125,000 annually after operating costs. Based on the previously mentioned cap rate equation, the cap rate will be as follows:
($125,000 / $900,000) 100% = 13.89%
Do you want to know what is a good cap rate? Read What’s a Good Cap Rate for Investment Properties?
Performing the calculations of cash on cash return vs cap rate is an important skill that every real estate investor should acquire.
Cash on Cash Return vs Cap Rate: The Usage
There are different uses for both the cash on cash return and the cap rate that help you better assess the performance and potential profitability of a certain real estate investment. Their uses are as follows:
Uses of Cash on Cash Return
- Helps in conducting an investment property analysis to evaluate real estate investments’ profitability
- Allows the process of comparison between different investments or real estate properties
- Evaluates the long-term performance of real estate investments
- Helps an investor choose investment property financing for the highest ROI
Uses of Cap Rate:
- Differentiate between different investment opportunities
- Checks the performance of certain real estate investments
- Helps in the process of analyzing real estate investments
Essentially, the major difference in the use of each metric lies in the fact that cash on cash return takes financing into account while the cap rate does not.
Are you curious to know more about investment property analysis? Make sure to check out Investment Property Analysis: Real Estate Investing
Cash on Cash Return vs Cap Rate: Conclusion
Both the cash on cash return and cap rate are very important factors and elements to determine the success and profitability of a certain real estate investment. With that being said, it is extremely important for real estate investors to know how to perform these calculations before deciding on buying or investing in a property. These metrics help you in forming successful investing decisions which leads to making successful real estate investments.
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