If you’re considering investing in rental properties, you’ve likely come across the terms “cash on cash return” and “capitalization rate” (cap rate). Both are metrics used to analyze and compare different real estate investment opportunities. However, they are not the same and measure slightly different things. Let’s take a closer look at each concept.
Cash on Cash Return
The cash on cash return calculates the annual cash income you’ll receive from a property relative to the cash invested. It takes into account the income from rents, as well as expenses like the mortgage payment, maintenance, insurance, taxes, etc.
Calculation
Cash on cash return is calculated by dividing the annual pre-tax cash flow by the total cash invested. The formula looks like this:
Cash on Cash Return = ( Annual Pre-tax Cash Flow / Total Cash Invested ) Ć 100%
Example
If you purchase a property for $100,000, invest $25,000 in cash as the down payment, and the property generates $5,000 in annual pre-tax cash flow, your cash on cash return would be 20% ($5,000 / $25,000).
A higher cash on cash return is better as it means you’re generating more annual cash flow relative to your investment.
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Capitalization Rate
The cap rate shows the potential return you’ll get based on the property’s income and value. It doesn’t factor in the mortgage or cash invested. It’s a measure used to compare different real estate investments, regardless of how they are financed.
Calculation
Cap rate is calculated by dividing the property’s net operating income (NOI) by its current market value or purchase price. The formula looks like this:
Cap Rate = ( Net Operating Income (NOI) / (Property Value or Purchase Price) ) Ć 100%
Example
If a $300,000 property generates $24,000 in net operating income (rents minus expenses), the cap rate is: $24,000 / $300,000 = 8%
A higher cap rate can signal the property is a good investment as it has a higher return relative to its value.
Comparing Cash on Cash Return and Cap Rate
While both metrics are useful, they serve different purposes:
Purpose
Cash on cash return measures the return on the actual cash invested, offering a clear picture of an investor’s cash flow. Cap rate, however, provides an overview of the potential return on a property, assuming it was purchased in cash, making it a good tool for comparing different investment opportunities.
Influence of Financing
Cash on cash return is influenced by the property’s financing. It considers the loan amount, interest rates, and other related costs. Cap rate ignores financing altogether, focusing solely on the property’s income potential relative to its price.
Use Cases
Cash on cash return is particularly useful for investors who want to understand the performance of their invested cash over time, especially when leveraging mortgages or loans. Cap rate is ideal for comparing various investment opportunities in a straightforward, finance-agnostic manner.
Conclusion
While cash on cash and cap rate both analyze returns for rental properties, they are distinct metrics. Cash on cash looks at your actual annual cash flow relative to invested cash. Cap rate looks at the overall return based on the property’s value and income potential.
When analyzing potential investment properties, it’s wise to calculate and compare both the cash on cash return and cap rate. Using these together can give you a more comprehensive view of a property’s return and cash flow profile
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