The return on investment is the metric used for measuring the profitability of an investment or an income property based on a number of different values and methods of calculation.
In real estate investing, the two main metrics used for calculating the return on investment for an income property are the cap rate and the cash on cash return values.
But what are these metrics? And how can you calculate them to determine the value of an income property and the return on investment that it will have?
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Return on Investment
The return on investment is the measurement of an investment and the amount of profit that it will generate for the amount of cash invested in it.
In real estate investing, the calculation of return on investment is crucial, and any real estate investors should base their decisions on the return on investment value that they estimate for their investment property.
There are multiple different methods and metrics used to calculate the return on investment in real estate, the two most prominent being the cap rate and the cash on cash return values.
These metrics have different uses in real estate investing, and they provide different insights into the investment property that is being analyzed to determine its profitability using a number of different values.
There are also a number of tools and investment property calculators that real estate investors have access to which can be used to further facilitate the process of calculating the return on investment quickly.
Also Read: Understanding Real Estate Return on Investment
The Cap Rate
The cap rate (capitalization rate) is a metric used in investment analysis to determine the amount of profit that an income property will generate in relation to its current market value.
In real estate, the cap rate can be best used for analyzing rental properties based on the amount of profit that the rental property will generate from its rental income.
This value is typically expressed as a percentage, which indicates the percentage of the rental property’s value that is being generated through your rental income on an annual basis.
The cap rate value is calculated using the following formula:
Cap Rate = (Net Operating Income (NOI)/Current Market Value) x 100
To make it simpler, imagine a rental property that is listed on the market for $400,000. The property is expected to generate $1,200 in monthly rent (after subtracting the operating expenses and the vacancy rate), which is an annual NOI of $14,400.
Based on this information, the cap rate of this property would be calculated as follows:
Cap Rate = ($14,000/$400,000) x 100
Cap Rate = 3.5%
This means that the property’s ROI is equal to 3.5% of the rental property’s value, or that the property will generate a profit equal to 3.5% of its total value each year.
Related: How Is Cap Rate Used for Evaluating a Real Estate Investment?
The Cash on Cash Return
The cash on cash return is a metric used for analyzing a rental property and determine its return on investment based on the amount of cash invested in it.
The cash on cash return metric is unique in that it only takes into account the amount of actual cash that the real estate investor has paid for the purchase of a rental property, leaving out any amount of borrowed money from a mortgage or a loan.
Similar to the cap rate, the cash on cash return value is expressed as a percentage, and the formula for calculating it is as follows:
Cash on Cash Return = (Net Operating Income (NOI)/Cash Invested) x 100
To illustrate, imagine the same $400,000 rental property from our last example, with the same amount of NOI ($14,400).
For this example, we will assume that you’re using a mortgage to finance 80% of the property’s price, which means that you will be paying 20% of the property’s price in cash, or an amount of $80,000.
Based on this information, the calculation of the cash on cash return for this rental property would be as follows:
Cash on Cash Return = ($14,000/$80,000) x 100
Cash on Cash Return = 17.5%
This means that the cash generated from the rental property each year will be equal to 17.5% of the amount of cash that you’ve invested in the property.
Related: Cap Rate vs Cash on Cash Return
Investment Property Calculator
Although the formulas for calculating the cap rate and the cash on cash return metrics are relatively simple and easy to handle, when doing investment analysis, it is generally a good idea to do comparative market analysis.
What this means is that in order to get the most accurate and reliable results, and in order to make use of the values calculated, real estate investors will have to gather enough data to do the same calculations for a number of different properties in each housing market, which would make the process daunting and time-consuming.
For this reason, real estate investors usually rely on technology in order to achieve the best results in the least amount of time.
This is where an investment property calculator comes in handy.
An investment property calculator allows real estate investors to calculate the different metrics used to measure an investment property’s return on investment with a very high efficiency by allowing investors to enter each value, such as the NOI or the expenses separately, and the calculator will automatically give you the result for the metric of your choice (cap rate or cash on cash return) without having to use a spreadsheet and to calculate them manually.
This tool can be very valuable to real estate investors who are actively seeking new investment properties and expanding their real estate investment portfolio, as it can reduce the amount of time needed to do these calculations from taking months of research to only taking a few minutes.
Note: Click here to find rental properties with readily calculated cap rate and cash on cash return!
Bottom Line
Real estate investment analysis is crucial for determining the value of an investment and its viability and profitability. The return on investment is one of the most important things to keep in mind when doing investment analysis, and it will give you a clear estimation of the amount of profit that an income property can generate from its rental income.
The different metrics that are used for calculating the return on investment of an income property vary and each has its own advantages and disadvantages when it comes to analyzing an investment property.
If you’re looking to find investment properties that have their cap rate and cash on cash return values already calculated for an easy and quick assessment, type in the name of the area of your interest in Mashvisor’s search bar, and pick the best investment property for your investment from the listings that we have in that area.
