What are the most commonly used metrics for calculating the return on investment in real estate?
When making a real estate investment, one of the most important steps for achieving success and making a profit is to calculate the return on investment to make sure that your investment will be a profitable one.
There are several methods that are used by investors to calculate the return on investment, and each of them serves a different purpose or is suitable for different types of investments.
In real estate investing, the most common metrics for calculating the return on investment are the cap rate and the cash on cash return.
Both of these metrics can be used for multiple types of investment properties, but are most useful when used for assessing a rental property before purchasing it.
The cap rate is a very popular metric that real estate investors use to determine the rate of return that their investment property will have based on the rental income of the property, its expenses, and its current market value.
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The biggest limitation of the cap rate is that it does not take into account the method of financing used for purchasing the property. It is, however, the best metric to use when comparing a number of properties to determine which one is most worth it for investing based on the amount of rental income that the property will generate and its price.
The formula for calculating the cap rate is fairly simple:
Cap Rate = (Before-Tax Cash Flow/Current Market Value) x 100
The cash flow of a property is the amount of rental income that it generates minus the expenses. The before-tax cash flow, as the name suggests, is the cash flow without accounting for the income taxes.
The cap rate is a percentage-based metric, and it indicates the percentage of the total value of the property that will be generated in profits on a yearly basis.
Cash on Cash Return
The cash on cash return is a very similar metric to the cap rate. The difference between the two metrics is that the cash on cash return does take into account the method of financing used to purchase the property.
This is because the cash on cash return, as the name suggests, calculates the return on investment based on the amount of cash that the investor has paid from their own pockets.
The cash on cash return is a very useful metric when assessing the return on investment of a rental property before buying it and after you’ve determined the method of financing that you will use and the amount of mortgage that you will take.
The formula for calculating the cash on cash return is as follows:
Cash on Cash Return = (Before-tax Cash Flow/Total Cash Invested) x 100
The cash on cash return is also very useful when investing in properties that require repairs and renovations, as these expenses can be added to the cash invested in order to give a more accurate return on investment value.
Related: What Is a Good Cash on Cash Return?
Both the cap rate and the cash on cash return are very useful metrics for calculating the return on investment and determining the value of a property before investing in it.
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