When investing in real estate, it’s important to consider a lot more than the face value of the purchase price to determine the value of the investment. You may also look at the appraised value of the property, the comparative market analysis, or even the price per unit to determine if the property is a good investment for you.
The price, the appraisal, the market analysis, and the price per unit are all tools that will help you understand the value of the property itself, but when you want to consider property value for the sake of investment, you will also need to know how much money that property can earn for you.
To find the investment value of the property, you need to consider the price of the investment in addition to the profits of the investment. There are many ways to do this, and investors may use various methods to estimate the investment property’s value. Each tool is a formulaic way to determine the property’s value by comparing different investment variables. The resulting percentages can be easily compared with other investment opportunities to determine which investment property is more valuable to the investor.
Cap rate and cash-on-cash return are two metrics in real estate. To help you have a clear understanding of the investment value when you see it, we will break down cap rate for real estate and cash-on-cash returns to explain how they compare to one another and provide the formulas for calculating these valuations.
Capitalization Rate (Cap Rates)
The capitalization rate compares the annual return or potential return of real estate to the property’s market value. Cap rates use the property’s price (or market value) and the property’s net operating income (NOI) to provide a valuation percentage. NOI takes into account all potential income and expenses the property will incur during the first year.
In real estate, the cap rate forecasts the potential profit of a property as a percentage. A higher percentage indicates a higher return. The formula can also be used to measure risk, such as comparing the cap rate of a property to the market cap rate of comparable properties. The cap rate will be the same for every investor.
The cap rate formula is effective only for estimating income-producing property or the potential rental income of an unoccupied property. Since the market type impacts the cap rate, you should use it to evaluate comparable properties in the same market area.
Capitalization Rate = Net Operating Income/Current Market Value
The formula for the cap rate is the NOI divided by the property’s current market value. For example, a property purchased for $500,000 with an NOI of $25,000 for the first year will have a cap rate of 5%.
Some of the negatives of cap rates are that:
- The formula only takes into consideration the first year’s expected income.
- Cap rates don’t factor in debt or taxes on the property. Mortgage and tax payments will reduce annual income below the cap rate estimations.
- Cap rates will frequently change as the market value of the property fluctuates.
Cash-on-Cash Return (Yield or Rate of Return)
The cash-on-cash return — also known as the yield or rate of return — measures how quickly the investor will receive the amount of cash invested in their property. Cash-on-cash return compares the cash invested with the first year’s before-tax cash flow. The cash invested includes the down payment, acquisition closing costs, and any initial repairs or upgrades made to the property. The before-tax cash flow considers all rent received, other income received, expenses paid, and debt service costs.
The cash-on-cash return is expressed as a percentage. A higher percentage projects a quicker return on investment. The formula can also project how to get a specific before-tax cash flow amount or how much total cash must be invested to yield a specific return.
Cash-on-cash return rates are useful because they are simple and can help investors compare not only real estate investments but also other types of investments. They are also particularly helpful because they highlight the effect debt payments will have on cash yields.
There are many variables to what constitutes a good cash-on-cash return due to investor needs and markets. Each investor prioritizes different preferences based on the property market, resulting in contrasting desired return percentages.
Cash-on-Cash Return = Annual Pre-Tax Cash Flow/Total Cash Invested
The formula for the cash-on-cash return is the yearly pre-tax cash flow over the total cash invested in the property. For example, a $500,000 property purchased with $250,000 in cash that had a $15,000 before-tax cash flow ($25,000 NOI – $10,000 paid in mortgage interest) would have a cash-on-cash return of 6%.
There are some negatives of cash-on-cash returns, including:
- Cash-on-cash returns only take into consideration the first year’s cash flow.
- They do not consider tax payments, which will decrease the actual rate of return depending on depreciation rates.
- In some cases, the annual cash flow amount can mislead the cash-on-cash rate of return if part of the cash received by the investor is a return on their original investment.
Which Should You Use: Cap Rate or Cash-on-Cash Return?
When comparing cash-on-cash return vs. cap rate, neither formula is the “correct” one to use. The option you choose depends on what you want to learn about the investment properties you have purchased or are considering purchasing.
Cap rate allows you to compare similar properties in one market. You can assess the annual or potential income against the market price to determine if the cap rate is desirable for your investment needs.
Cash-on-cash return is influenced by leverage, which is debt that can increase the potential return. With leverage, you can invest less capital into the purchase, decreasing the “total cash invested” value in the cash-on-cash return formula and yielding a higher percentage.
Learn More About Cap Rates and Cash-on-Cash Returns From 1031 Crowdfunding
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