When investing in real estate, you may often come across terms like cap rate and cash on cash return. These two terms are two different forms of ROI or return on investment. Return on investment is a very general term that encompasses your overall return on investment. Less generally, cash on cash return and cap rate are more specific real estate metrics to measure return on investment. But what is a good cap rate and what is a good cash on cash return? This blog is dedicated to explaining both terms in depth and showing how to use them when making real estate investing decisions.
Capitalization Rate: Definition
Cap rate, short for capitalization rate, is the rate of return on a real estate investment property based on how much income you believe the property is going to generate. Calculating the cap rate is important to see if you are buying an investment property at a good price. Moreover, cap rate is used to valuate a real estate property based on market cap rates of recently sold comparable properties. Before explaining what is a good cap rate, let’s give an example of how to calculate it.
Cap rate formula
Cap rate= Net Operating Income (NOI) / Market value of property
For the purpose of finding out what is a good cap rate, the above equation is reversed to figure out which cap rate corresponds to a higher net operating income.
Example: What is the NOI of two investment properties having the same market value of $250,00 and cap rates, 10% and 15% respectively?
1- NOI of property #1 = 10% X $250,000 = $25,000
2- NOI of property #2 = 15% X $250,000 = $37,500
By just looking at the results above, it is clear that a higher cap rate implies a higher NOI. But to decide what is a good cap rate, you need to look at other factors.
What is a good cap rate?
Different cap rates represent different levels of risk. High cap rates imply high risk and low cap rates imply lower risk. To really understand what is a good cap rate for an investment property, you should look at several factors:
- Location: Location is the main driver for demand. This is why different cities and even different areas within the same city have different cap rates. Normally speaking, real estate properties near downtown have lower cap rates than properties in the suburbs. Demand for centrally located real estate is higher, thus reducing levels of risk. Therefore, when buying an investment property, a higher cap rate is not always the best decision.
- Interest rates: If you are a real estate investor, you should be aware of the current interest rates. When interest rates rise, cap rates rise as well due to the fall of property values. However, this is not in your favor because it also corresponds to higher mortgage costs and thus, a decrease in your net cash flow.
- Property type: Different investment properties have different cap rates. A property that has the lowest perceived risk usually has the lowest cap rates.
Therefore, a higher cap rate does not necessarily imply a better investment property, unless you are comparing similar properties in the same location.
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Cash on Cash Return: Definition
Cash on cash return is another important rate of return used to evaluate a real estate investment performance. CoC return calculates the cash income earned on cash invested in a real estate property. Utilizing cash on cash when doing an investment property analysis has its pros and cons. Pro: it is easy to calculate and it provides a quick and easy way to compare different investment opportunities. Con: it doesn’t consider the time value of money and property appreciation.
CoC return formula = Annual operating income / cash invested
The main difference between cash on cash return and cap rate is that CoC return is calculated with the financing cost included as an expense, while in cap rate calculation, it is not. Therefore, if you buy an investment property all-cash, the cash on cash return will be the same as the cap rate. If you buy a property all-cash, both “cash invested” and “property value” will be the same, as well as the net operating income since financing costs are nil.
Before explaining what is a good cash on cash return, let’s take a look at how it is calculated. Assume you buy a rental property worth $250,000 with $50,000 cash down payment. For a long-term 30 years loan at 5% interest rate, your annual mortgage payment would be around $15,000. After deducting operating expenses, vacancy costs, property management costs, and property insurance, your rental income will be $20,000 (assuming rent per month is $2,500 and NOI is 2/3 of gross potential income).
CoC return = ($20,000-$15,000)/$50,000 = 10%
What is a good cash on cash return?
The answer to what is a good cash on cash return is very subjective. Real estate experts disagree on the exact numbers, but some say anything between 8% and 12% is worth exploring a little bit further, while other real estate investors aim for CoC return of 20%. So what is a good cash on cash return? It really varies from one investment property to another and depends on WHERE you are investing.
The Bottom Line
When making real estate investing decisions, you should never rely on a single metric or ratio to assess whether a property is a good or bad investment. The answer to what is a good cap rate and what is a good cash on cash return is subjective to property type, location, and the time the real estate property is bought.
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