Understanding Cap Rate and Cash-on-Cash Return

Investing in real estate can be a great way to generate passive income and build long-term wealth. To do that, you need to understand the metrics and formulas used to evaluate a property. In this article, we’ll cover two of the most common metrics used by real estate investors: cap rate and cash-on-cash return.

What is a Cap Rate?

The capitalization rate (cap rate) is a formula used to determine how much an investor can expect to earn on a given property. It’s calculated by taking the net operating income (NOI) of the property and dividing it by the purchase price of the property. The higher the cap rate, the more income the investor can expect from the property.

For example, if a property has a NOI of $60,000 and a purchase price of $400,000, the cap rate would be 15% (60,000 / 400,000 = .15). That means that for every $400,000 invested in the property, the investor can expect to earn $60,000 in net operating income.

What Influences Cap Rate?

There are several factors that can influence the cap rate of a property:

• Location: A property located in a prime area may have higher rent prices and greater demand, resulting in a higher cap rate.
• Markets Conditions: If the market is experiencing a downturn, property prices may fall and cap rates may rise.
• Building Condition: A building in need of repairs or upgrades may have lower rent prices and a lower cap rate than a well-maintained building.
• Competition: If there is a lot of competition in the area for rental properties, the cap rate may be lower.

What is Cash-on-Cash Return?

The cash-on-cash return is a metric used to measure the return on investment for an income producing property. It’s calculated by taking the net operating income (NOI) of the property and dividing it by the total amount of cash invested in the property. This formula can be used to compare different investment opportunities.

For example, if a property has a NOI of $60,000 and an investor invested $200,000 in the purchase of the property and improvements, the cash-on-cash return would be 30% (60,000 / 200,000 = 0.3). That means that for every $200,000 invested in the property, the investor can expect to earn $60,000 in net operating income.

What Influences Cash-on-Cash Return?

Similar to the cap rate, there are several factors that can influence the cash-on-cash return of a property:

• Financing: If the property was purchased with a loan, the amount of cash invested in the property may be less than the purchase price due to the loan’s interest rate and down payment.
• Offers: If the investor is able to negotiate a discounted purchase price, the cash-on-cash return will be higher.
• Expenses: The amount of cash used to cover operating expenses can affect the cash-on-cash return.
• Timing: If cash is re-invested in the property on an ongoing basis, the cash-on-cash return can increase over time.

Cap Rate vs. Cash-on-Cash Return

Understanding the difference between cap rate and cash-on-cash return can help investors determine which formula is most appropriate for the property they are evaluating.

The cap rate is most useful when evaluating properties with similar purchase prices and NOIs, as it measures the return on a dollar-for-dollar basis. The cash-on-cash return, on the other hand, is best used when evaluating properties with different purchase prices and NOIs, as it measures the return on the total amount of cash invested in the property.

Conclusion

The cap rate and cash-on-cash return are two of the most commonly used metrics to evaluate real estate investments. Knowing how to calculate each one is essential for investors looking to make informed decisions about their investments. Understanding the difference between the two formulas and how they are impacted by various factors can help investors evaluate potential opportunities and make informed decisions about which investments to pursue.

What is the difference between Cap Rate and Cash-on-Cash Return?

Cap Rate is a calculation measuring the ratio of net operating income (NOI) to the purchase price of a real estate investment. It is used to measure the potential return of the investment. Cash-on-Cash Return is the return an investor receives on their cash investment when compared to the cash generated from the investment. It is the ratio of the net annual pre-tax cash flow to the total amount of cash invested in the property.

What is the formula for calculating Cash-on-Cash Return?

Cash-on-Cash Return = (Net Operating Income / Total Cash Invested) x 100

What factors are considered when calculating Cash-on-Cash Return?

1. Initial Cash Investment: The initial amount of cash required to acquire or initiate a property or investment.

2. Net Operating Income: The annual income generated from the property or investment that is available to cover debt service and other expenses.

3. Loan Financing: Financing used to acquire the property or investment, such as interest rate and terms of the loan.

4. Capital Investment: Any additional capital outlays required to maintain or improve the property.

5. Interest Rate: The interest rate when calculating cash-on-cash return.

6. Operating Costs: Operating expenses including costs for property taxes, insurance, and repairs.

7. Tax Advantages: including both federal and local incentives and deductions.