There are a number of different means used to determine the return on an investment property. Real estate investors typically calculate the return on investment (ROI); however, ROI is very general and includes a lot of estimates and unproven numbers. Today, we’re discussing two more specific measures for different types of investments in real estate – cap rate and cash on cash return.
What Is Cap Rate?
The capitalization rate (or cap rate, for short) relates the sale price of the investment property to the rental income which the rental property is expected to generate. In simple words, the capitalization rate is a measure of profitability used to estimate the real estate investor’s potential profit from his/her investment property.
Calculating Cap Rate
The cap rate of an investment property can be calculated by dividing the net operating income (NOI) of the investment property by the current market value of the property (the purchase price), where NOI equals the annual return on the retnal property minus all operating costs. The formula for calculating the capitalization rate is as follows:
Cap Rate = Net Operating Income/Current Market Value
For example, if a real estate investor buys a property for $900,000 and expects that the property will generate $125,000 per year, the capitalization rate of his/her investment is:
Cap Rate = $125,000/$900,000 = 0.1389 = 13.89%
This means that every year the investor is earning 13.89% of his real estate property’s value as profit.
Related: Why Is the Cap Rate Used in Real Estate? How Do You Calculate It?
Uses of Cap Rate
Cap rate is useful to measure how risky a real estate investment is; a higher cap rate corresponds to a higher level of risk, thus a higher prospected profitability and the opposite holds true as well. This helps real estate investors compare different rental properties, and accordingly, determine whether investing in a certain property is worthwhile or not.
Often, comparing different property investments based on the market value or the operating income can be difficult and can yield complicated numbers and results. On the other hand, comparing percentages is very straightforward. When real estate investors determine which properties are good investments and which are not, many of them often set a minimum cap rate percentage which they will accept and believe will make the real estate investment worth their while.
Another use of the cap rate is to check how an investment property is doing over a period of time and whether or not it’s improving. It is a good sign when you see that the cap rate of your investment property is increasing. Vise-versa: if cap rate is declining, maybe you should reconsider your investment.
It is important to mention that the cap rate is a comparative real estate profitability metric; it is most valuable when used to compare against very similar properties – that is, properties with a similar location, of a similar property type, and valued at the same point in time.
Related: How to use cap rate to decide on the best investment
What Is Cash on Cash (CoC) Return?
Cash on cash return is another real estate metric which calculates the cash income earned (cash flow) on the cash invested in an investment property. For example, when purchasing a rental property, a real estate investor might put down 10% as a down payment. Cash on cash return measures the annual return the investment makes in relation to the down payment only. In other words, CoC return is the return on the money (the cash) we actually invest.
Calculating Cash on Cash Return
The formula for cash on cash return is as follows:
CoC Return = Annual NOI/Total Cash Investment
For example, suppose a real estate investor’s annual NOI for the property was $15,000, and that the investor had put down a $60,000 as a down payment. Then, the cash on cash return would be:
CoC Return = $15,000/$60,000 = 0.25 = 25%
Uses of Cash on Cash Return
Cash on cash return is generally used to measure commercial real estate investment’s performance. Similarly to the cap rate, cash on cash rate helps real estate investors and business owners evaluate whether their investment is performing well or not.
The cash on cash return rate can also be used to forecast cash distribution and potential future cash flow over the life of the investment.
The Main Differences Between Cap Rate and Cash on Cash Return
1. The main difference between the two real estate metrics is the number you use in the denominator of the equation: either the purchase price or the actual cash invested.
2. Cap rate tells you how much you’d make on a real estate investment if you paid all cash for it. Thus, if you purchase a rental property with all cash, the value of cash on cash rate will be the same as the value of the cap rate.
3. Financing costs, such as mortgage cost, are included as an expense when calculating cash on cash return, but they are not included in the calculation of cap rate.
Related: How Can You Plan for the Best Cash on Cash Return?
Conclusion
When it comes to determining the return on an investment property, two real estae metrics are mostly widely used: the cap rate, used to tell you how much profit you’d generate from an investment property, and the cash on cash return, used to measure the performance of real estate investments. Each one has different uses and can be calculated to help real estate investors determine the best property for investment.
Mashvisor’s investment analytics provides you with information such as expected rental income and Airbnb occupancy rates, in addition to cap rate and CoC return for specific properties in addition to neighborhood and city averages. Moroever, all these metrics are divided for traditional rentals and Airbnb rentals. Mashvisor’s features will help you in browsing, comparing, and selecting the best property among several types of investments.