Figuring out the return on investment can sometimes be overwhelming for beginner real estate investors. There are so many terms real estate investors use: positive cash flow, cash on cash return, cap rate, rate of return, etc.
Real estate investors want to make sure they will be making money from a real estate investment, but aren’t always sure how to determine this. This is because the return on investment can be calculated using a few different real estate metrics.
Capitalization rate (cap rate) and cash on cash return are two real estate metrics of return on investment that a lot of real estate investors confuse. How do you calculate each one and when exactly do you use these real estate metrics?
Cap Rate
Cap rate shows real estate investors the return on investment of an investment property based on the rental income that it will bring in. The equation used to calculate cap rate is:
Annual Income/Property Price= Cap Rate
One mistake real estate investors might make when calculating the cap rate is their estimate of the annual income. The annual income is not the same as the gross income of an investment property. While both include the rental income along with other forms of income, gross income doesn’t factor in any of the expenses of the investment property. To avoid making mistakes in your calculations, use Mashvisor’s investment property calculator. It will help you get the numbers quickly and accurately.
A real estate investor must perform an investment property analysis and estimate the expenses. These expenses are subtracted from the gross income to give you the net annual income of the investment property. It may be easier to figure out the monthly net income and then multiply that number by twelve.
When to Use the Cap Rate
Real estate investors will find that they have to use the real estate metric of cap rate when buying or selling an investment property. Cap rate will let a real estate investor know if the investment property is being sold at a good property price or not. It will also help a real estate investor determine the right property price for his/her real estate property when he/she chooses to sell.
Cap Rate When Buying an Investment Property
When buying an investment property, real estate investors can’t avoid the cap rate. From all of the real estate metrics, it is the one that is listed most often for an investment property. Cap rate will let real estate investors know if the property price is too high or too low based on the rental income the investment property generates. A very low cap rate means that the property price is way too high and the real estate investment will be a bad one.
The reason cap rates are found in investment property listings is that the cap rate is independent of the individual real estate investor and completely dependent on the real estate property itself. So, when an investment property goes up for sale, there is no way the property seller can use the cash on cash return in order to market the real estate property.
Real estate investors have to be cautious when looking at the cap rates of an investment property they are interested in. A lot of property sellers will use numbers that are less than realistic in order to get better cap rates to convince property buyers it’s a good real estate investment. They could use lower expenses or higher rental income that doesn’t factor in the actual vacancy rate of the area. Ask for the numbers that were used to calculate the cap rate in order to determine if the investment property is a good investment or not.
Related: What’s a Good Cap Rate for Investment Properties?
Cap Rate When Selling an Investment Property
Because other real estate investors are using the cap rate when they sell, you should use this real estate metric when you choose to put up your real estate property for sale as well. Because real estate investors looking to buy a property are presented with cap rates, yours will have to compare and compete if you want to see a return on your investment. Choosing a property price will depend on the cap rate that it gives. Perform an updated investment property analysis, factoring in any changes in the property that affect rental expenses and rental income (such as a change in the rental income or repairs that add to value) and figure out a fair property price for both you and the property buyer.
Cap rate is also useful when a real estate investor is attempting a real estate market analysis. Sometimes, real estate investors find it difficult to find real estate comps for their real estate property. When this is the case, the cap rate of the market is a good alternative. Find the cap rate of the market and work backward to find a property price for your real estate property.
Related: Finding and Understanding Rental Comps Made Easy
Cash on Cash Return
Successful real estate investors look at all of the real estate metrics they can before deciding to invest in real estate. But if you were to depend on one real estate metric, let it be cash on cash return. Unlike cap rate, cash on cash return will actually let a real estate investor know how much of a return he/she will get on the money he/she invests in real estate.
Cash on cash return is totally dependent on the real estate investor and the financing method used. Financing is the major difference between cap rate and cash on cash return. Investing in real estate using cash rather than financing from a bank would actually make the two numbers equal.
Related: Buying an Investment Property: Cash or Mortgage?
Cash on cash return is calculated with the following equation:
Cash Flow/Cash Invested= Cash on Cash Return
Similar to the cap rate, annual income is calculated after an investment property analysis is carried out to find the rental income and any expenses the real estate property will require. Here, the annual income not only factors in expenses of the investment property but also the financing. That is why cash flow is used in the equation (cash flow = annual income – debt). Financing includes the down payment, monthly mortgage payments, and interest rates.
Remember, successful real estate investors look for positive cash flow properties. Positive cash flow means that after all monthly expenses and financing, your real estate property will still be making money. Positive cash flow will give a real estate investor the best cash on cash return, and in turn, the best return on investment.
When to Use Cash on Cash Return
As mentioned, real estate investors have to evaluate cap rate when buying an investment property, because it is what will be advertised. However, when investing in real estate, cash on cash return must be calculated. A cap rate might be high for a real estate property, which means it’s worth looking into. Financing will, however, also play a role as to whether or not you are able to invest in real estate. For example, if a real estate investor is forced to put down a really large down payment (possibly due to poor credit or no credit at all), this will lower the positive cash flow and affect the cash on cash return. Ultimately, the return on investment won’t be as great with this particular real estate investor’s financing, despite the good cap rate for the property.
Understanding real estate metrics is the key to investing in real estate and making money from real estate investments. Both cap rate and cash on cash return hold their own significance, and real estate investors need to know how and when to utilize them properly in order to be successful when it comes to investing in real estate.
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