As a beginner investor, you sure want to know how to calculate cap rate as well as cash on cash return for rental properties. This guide is just what you need for that!
Let us get straight to the point; both metrics are essential for the best cash flow investments. However, they are two different approaches that will get you to one conclusion: the return on investment!
How to Calculate Cap Rate vs. How to Calculate Cash on Cash Return: Definition
Simply put, a cap rate is a way to evaluate the amount of income a property generates relative to its overall price. So, on that basis, you notice there are two variables involved: income and total property price.
The simplest way to put cash on cash return is “cash in vs. cash out.” Being a way of calculating the return on investment, the cash on cash return focuses on the cash return for every actual dollar you invest. Its two variables are the NOI (same as the cap rate) and the amount of money you have invested, excluding all financing methods other than cash.
How to Calculate Cap Rate vs. How to Calculate Cash on Cash Return: Variables
On one hand, there is the Net Operating Income (NOI) that both measures share. You can also call it the annual cash flow. Basically, it is the rental expenses subtracted from the gross monthly rental income. The rental expenses include the following:
- Legal work and accounting
- Property management
- Vacancy rates
- Any unexpected expenses
After you have subtracted these from the rental income, you get what we call the cash flow. Multiplying this figure by 12 gives you the annual cash flow or the NOI.
On the other hand, the property price for the cap rate is pretty obvious. It is the fair market value of the property you intend to buy or already own.
As for the cash on cash return for rental properties, you divide the NOI by the amount of money that came out of your pocket. This includes the down payment as well as any other expenses relative to the property that contribute to your equity possession.
How to Calculate Cap Rate vs. How to Calculate Cash on Cash Return: Significance
You could sum up the significance of the cap rate for rental properties in two points:
- Analyzing different investment opportunities. It is, in fact, a radar for the best cash flow investments in real estate.
- The cap rate sometimes helps form real estate market trends. So, calculating it is actually helpful in terms of predicting where the market is heading.
The importance of cash on cash return for rental properties comes in two different forms:
- It is perfect for detecting positive cash flow opportunities in residential real estate investing.
- With long-term investments, a real estate investor can know the exact return on investment in reference to how much they actually invested.
How to Calculate Cap Rate vs. How to Calculate Cash on Cash Return: Key Factors
There are always key factors that affect the calculation of any type of profitability measure. For both the cap rate and the cash on cash return, there is one important factor: location. In fact, it is the number one component of rental property analysis so pay close attention to it.
The importance of location is the number one rule you are going to learn in the business of real estate investing. Understand that, in 99% of the cases, location is what determines a good cash on cash return or a good cap rate. Overall, a profitable location promises a good return on investment through both metrics.
When it comes to revealing the best locations for your rental properties, one type of analysis comes to mind: The real estate market analysis, otherwise known as the comparative market analysis. This deals with the surroundings of the property in terms of facilities, appreciation and the potential of the location. Mostly, however, it focuses on comparing the rental property to surrounding investment properties. It uses real estate comps to estimate the value of the property as well as the rent value.
How to Calculate Cap Rate vs. How to Calculate Cash on Cash Return: Metrics in Action
In this section, we are going to give an example and show you how to calculate cap rate vs. how to calculate cash on cash return for the same property.
Suppose John has found an investment property that is worth $200,000. He applied for a mortgage and he is expected to pay a 20% down payment ($40,000). After conducting the comparative market analysis, he found out that he could rent it for $1000/month. Also, let’s suppose that he is going to pay (per month) the following:
- $50 for insurance
- $100 for property management
- Set aside $100 for maintenance and any unexpected costs
- He pays $400 in mortgage payments
- Suppose he does not expect any vacancies during that particular year since he already has tenants who are ready to move in as soon as they close the deal.
So, what is the cap rate and what is the cash on cash return for this property?
How to calculate cap rate for this property?
First of all, calculate the NOI. As we said before, it is the rental income minus the rental expenses.
NOI = $1000 – (50+100+100+400) * 12 = $4,200 (positive cash flow)
Now apply that to the cap rate formula
NOI/property price*100% = $4,200/ $200,000 = 2.1%
How to calculate cash on cash return for this property?
The NOI is the same here. The only difference would be the second component. Instead of dividing the NOI by the property price, we are going to divide it by the number of actual dollars invested.
NOI/ actual dollars * 100% = $4,200/ $40,000 = 10.5%
**Pssst, you can skip all that hassle and use Mashvisor’s rental property calculator!
Making money in real estate is all about the right numbers. The higher the numbers, the better the investment opportunities. Since you have learned how to calculate cap rate and cash on cash return, check out our blog to learn all about the other real estate metrics as well. Mashvisor has it all designed especially for aspiring real estate investors like yourself.