Different strokes for different folks. Different calculations for different situations and comparisons. There is a difference between cap rates and cash on cash return and here’s what it is.
WHAT IS A CAP RATE?
Cap rate – or capitalization rate – is a measure of profitability of a real estate investment. More simply, it is how much of the value of the property the investor is receiving as profit. It is also a measure of risk. The higher the cap rate, the higher the risk and also the higher the return possibilty. The lower the cap rate, the lower the risk and the lower the return possibility. Every investor has their tolerance for risk and the required cap rate to make a turnkey invesment property worth it.
Cap rates are very useful because they help an investor compare multiple investment opportunities and decide whether or not an investment is worthwhile based on their personal threshold. You can also track how your investment is doing over time. If you see the cap rate increase year after year, the invesment is doing well. On the flip side, if you see the cap rate declining, you may want to rethink your investment.
How is a cap rate calculated?
Divide the net operating income (NOI) of an investment by the purchase price (market value). The formula would be as follows:
Cap Rate = Net Operating Income (NOI) / Purchase Price
*NOI = annual rental income – operating expenses (maintenance, taxes, management fees, etc).
For example, suppose you have a property with an NOI equal to $12,000 and a selling price equal to $100,000. The cap rate will be calculated as follows:
Cap rate = $12,000 / $100,000
Cap rate = 0.12 = 12%
Most of our turnkey investment properties in Dayton, Ohio, Middletown, Ohio, and Franklin, Ohio, bring turnkey real estate investors between an 8%-15% cap rate.
WHAT IS CASH ON CASH RETURN?
Cash on Cash – or CoC – return is another real estate tool which measures the relationship between cash invested and the cash flow, or net operating income of a property. CoC return measures the annual return on investment. It is especially useful if you are using financing for your turnkey invesments.
CoC return is an indicator of an investment’s performance. Essentially, how well an investment is doing. Cash on cash return can also be a way to forecast future cash flow returns on the property. CoC, very much like cap rates, can be used to evaluate how an investment is doing and whether it’s improving or not.
How is cash on cash calculated?
The formula for CoC return is as shown below:
CoC Return: Annual Net Operating Income / Total Cash Investment
For example, suppose your annual net cash flow for the year for your property was $12,000, and that you’ve put down $20,000 as a down payment for the property (this would be a 20% down payment on the above mentioned $100,000 property). Your CoC return would be calculated as follows:
CoC Return = $12,000 / $20,000
CoC Return = 0.6 = 60%
CAP RATE vs CASH ON CASH
If you purchase a property with all cash, the value of cash on cash will be the same as the value of the cap Rate. If you do not use a loan, if you pay cash for the purchase, then both denominators will be equal to the price of the property, and there will be no difference between cap rate and CoC return.
So what is the difference between using cap rate and cash on cash?
There are three main differences between cap rate and CoC return.
- If you do not purchase in all cash, the denominator in each equation will be different. It will be purchase price in cap rate calculation, and cash investment for CoC return.
- While CoC return considers the annual financing costs for the property, also identified as the annual investment, cap rates do not. So when calculating cap rate, you should never include any financing costs such as mortgage cost.
- Financing costs are included as an expense in the calculations of CoC return, but they are not in the calculation for cap rate.
In the end, each investor will have their own personal threshold for an investment opportunity and what makes sense to them. Cap rates show you how much you’re making off the value of the property. Cash on cash shows you how much you’re making off your money you invested in the property.
Interested in seeing how much money your money can make for you? Contact us! We’d love to chat about it. You’d be surprised how far a little investment can take you in just a few years.