Understanding Cap Rate vs Cash on Cash Return
One of the issues first year dental students face is becoming familiar with all of the “dental lingo” involved.
It took me a while to get comfortable with terms such as:
- probing depth (PD)
- loss of attachment (LOA)
This is no different when first starting to learn about real estate investing.
Occasionally you’ll hear terms tossed around such as:
- private placement memorandum (PPM)
- depreciation recapture
- Delaware statutory trust (DST)
- 1031 exchange
Don’t let the terminology scare you off as we all have to start somewhere during the learning process.
Speaking of starting somewhere, two of the most important metrics when it comes to analyzing the financial performance of income property is our topic for discussion today:
Cap Rate vs Cash on Cash Return
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What Is Cap Rate?
Cap rate, also known as capitalization rate, is used to indicate the rate of return expected for a particular property.
It’s based on a ratio of the current income to the market value of the property.
Investors use this metric to compare properties and estimate their potential ROI (return on investment) for a particular asset.
It’s expressed in a percentage and typically the higher the cap rate, the higher the projected profitability.
Cap Rate Calculation
You can either use an online cap rate calculator or perform the calculation by hand.
Either way, cap rates are calculated by taking the net operating income and dividing it by the market value.
Cap rate formula:
If the net operating income (NOI) isn’t provided, it can be calculated by taking the income received after expenses have been paid but before principal and interest payments, capital expenditures, depreciation and amortization.
Cap Rate Example
Dr. A decides that he wants to cut back on his time treating patients and start building additional income streams via real estate.
He’s worked with a local realtor and found an apartment building with the following stats:
- Property value = $1 million
- Rental income = $100,000
- Operating expenses = $60,000
- Net operating income (NOI) = $40,000 (Income – expenses) ($100,000 – $60,000)
Knowing the NOI and value of the property, Dr. A can calculate the cap rate:
$40,000/ $1,000,000 = 4% cap rate
In this example, a real estate investor can expect to receive an annual return of 4% from a rental property worth $1,000,000.
Uses Of Cap Rates
The main use of a cap rate is to relate the property’s sales price to the income it generates. It basically tells you if you’re getting a good buy or not.
For instance, if you’re buying too high for the area, then you can expect a lower than normal cap rate.
When buying a residential house, it’s usually easy to tell if you’re getting a good deal based on what other homes in the neighborhood are selling for.
But this can be more difficult when dealing with commercial property as there may not be many comparables to base a selling price off of in the area.
If this is the case, using the formula discussed above can help.
While the Cap Rate compares the purchase price of a property to the income it generates, the Cash-on-Cash Return (CoC) is what tells you how much return you make on the money you put in.
If you’re mainly looking to obtain the return on your money then the CoC return is your best bet (will discuss in further detail below).
Different cap rates can also be used as a measure of risk. Normally a higher cap rate has higher risk thus a larger possible profitability.
On the other hand, a lower cap rate has lower risk but also less probability of a higher return.
These different cap rates allow investors to compare different properties and determine whether investing in a certain property is worth it or not.
The main point to remember is that the cap rate is a comparative real estate investing profitability metric.
What Is a Good Cap Rate?
At the end of the day, cap rate is a single measurement at a single point in time, based on the current performance of a given rental property.
Cap rates don’t measure the potential of commercial real estate or how much you’ll receive in annual cash flow.
If you’re a passive investor like me, you should have a good grasp of the different terminology while choosing a real estate investment property.
Beyond that, you will find that cap rates aren’t as important as some people make them out to be.
What Is Cash on Cash (CoC) Return?
The cash-on-cash (CoC) return is a real estate metric that refers to the return on capital that’s invested in rental properties.
It provides a number (expressed as a percentage) that represents the relationship between the cash you invest and its cash flow.
For example, when purchasing a rental property, an investor might put down a 20% down payment.
The coc return measures the annual return the investment makes in relation to the down payment only.
It’s also an indicator of the performance of an investment property.
Calculating Cash on Cash Return
The formula for calculating a cash on cash return is as follows:
CoC Return: Annual Net Operating Income / Total Cash Investment
Remember, net operating income (not gross income) must be used in the calculation.
For example, if an investor put a $50,000 down payment on an office building with an annual net cash flow of $12,000, the CoC return could be calculated as follows:
- CoC Return = $12,000 / $50,000
- CoC Return = 0.24 x 100 = 24%
What Is a Good Cash On Cash Return?
Similar to the “What’s a good cap rate?” question, there’s no right or wrong answer to what makes a good cash on cash return.
Unfortunately, there’s no specific rule of thumb regarding what constitutes a “good” CoC or cap rate for that matter. It’s all subjective and comes down to the person investing in the deal.
Depending on the real estate market, some investors feel that a projected CoC of 8-12% is good while others believe that 5-7% is acceptable.
It also depends on the investor’s risk level. Those that are closer to retirement want to take on less risk vs others that have several years (or decades) of work ahead of them.
Again, it’s all about a person’s specific investment goals.
Key Takeaways For Cap Rate vs Cash on Cash Return
Some key points to remember are:
Cap rate compares the NOI generated by rental property to the purchase price. This allows an apples-to-apples comparison of similar properties in the same market.
It doesn’t matter if you, me or anyone else purchases the property, the cap rate (return) is the same. This is due to the fact that the mortgage payment isn’t included in the cap rate calculation.
As for the cash on cash return, it measures the potential profit an investor can expect to make on total cash invested.
Because this metric DOES include the mortgage payment, the same investment property can have different CoC returns based on different amounts of leverage.
My goal for this site is to educate you regarding the in’s and out’s of real estate investing. Heavy focus is directed on passive investing as most of us are busy and don’t want to be landlords.
As I continue to learn myself, I plan on passing along my wins (and losses) to you so you can make an educated decision what’s best for your investment goals.
The first step in the vetting process starts with the numbers and the cash on cash return is an easy metric to start with.
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