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As a real estate investor, understanding the differences between cap rate, ROI and cash-on-cash returns is an important skill. This guide explains what each of these metrics means for investors in rentable property investments.
The “cap rate vs cash on cash” is a term that is often used in the real estate industry. It refers to the amount of money that can be earned from an investment property, divided by the total cost of the property. The cap rate will vary depending on what type of property you are investing in and how much risk you want to take.
Capitalization (cap) rate, Investment Return on Investment (ROI), and Returns on Cash Invested are three common indicators used by real estate investors to evaluate the performance of an income-producing property. To gain the most accurate picture of a property’s prospective rate of return, it’s better to utilize all three. The yearly return divided by the entire investment is the Formula for Return on Investment.
When Should Real Estate Investing Formulas Be Used?
Generally, the more information you know about a property, the more informed your choice to buy it or maintain it in your portfolio will be. As a result, it is suggested that you use all three formulae. However, there are times when you may be pressed for time or just wish to apply a single formula to calculate a property’s rate of return.
Cap Rate
The rate of return on a property is measured by the cap rate. The Formula for calculating the cap rate, which is net operating income divided by current property value, may be used to establish a property’s cap rate. Typically, cap rate is used to compare two identical properties in the same property class, such as two commercial buildings.
Typically, buy-and-hold investors will look at the cap rate to evaluate how well the property does over the course of a year. However, since there is no rental revenue on fix-and-flip houses, cap rate cannot be applied. Keep in mind that the cap rate does not account for mortgage payments.
Investment Return on Investment
The return on investment (ROI) is a metric used to assess how well a piece of real estate is doing. It’s usually calculated by dividing your yearly return by your entire investment. In general, the smaller your cost, the larger your return on investment. You may utilize ROI on both fix-and-flip and buy-and-hold investments, and the ROI method takes into account your mortgage, while the Formula for calculating the cap rate does not.
Returns on Cash Invested
The cash-on-cash return is a real estate indicator that evaluates your asset’s performance. It also considers a property’s debt, like as your mortgage, which is comparable to ROI but not the same as applying a cap rate. The cash-on-cash return methodology varies, but it typically involves dividing your net operational revenue by your entire cash investment, which includes lending fees and closing charges.
Cap Rate vs. ROI vs. Returns on Cash Invested
Whether to use cap rate vs. ROI or Returns on Cash Invested is something that real estate investors have to decide when evaluating properties. Typically cap rate is used on multifamily properties, commercial buildings and apartment buildings. It’s not used on fix-and-flip properties because net operating income (NOI) is used in the Formula for calculating the cap rate and there isn’t any NOI for a fix-and-flip project because there’s no rental income.
Investors typically use cap rate to compare properties, in addition to also using Returns on Cash Invested, comparable property sales prices and ROI. Conversely, investors use ROI to analyze both long-term investment properties as well as fix-and-flip properties. The ROI is the overall rate of return on a property including debt and cash invested. ROI does take the debt on the property into consideration.
Both commercial and residential investors typically use Returns on Cash Invested to evaluate the cash flow coming in from income producing properties. However, it typically isn’t used by fix-and-flip investors since they don’t have any monthly rental income. Returns on Cash Invested typically provide a more accurate analysis of the investment property’s performance when compared to the property’s ROI. This is because Returns on Cash Invested only measure the return on the actual cash invested and doesn’t include the debt.
How to Calculate an Investment Property’s Cap Rate
Investors may use a cap rate calculator or compute the cap rate by hand. To calculate cap rate by hand, divide the property’s net operating income by the current property value and multiply by 100 to obtain a percentage. The cap rate is a measurement of a property’s rate of return over a year. Unlike ROI, it is exclusively utilized on income-producing properties, which are generally multi-unit homes.
Keep in mind that the cap rate is set based on yearly returns while calculating it. This implies that whether a property performs well or badly over the course of a year will be reflected in the cap rate calculation. It also implies that an investor isn’t obtaining a comprehensive picture of the property throughout the years.
For example, if the property had a few years of bad performance in the past, the cap rate may be misleading since it only reflects one year of good returns. When analyzing an investment property, it’s critical to consider more than one statistic.
Read our capitalization rate article for a more in-depth look, including what a good cap rate is.
Formula for calculating the cap rate
Formula for calculating the cap rate = NOI / Property Value x 100
For the first part of the Formula for calculating the cap rate, we need to find out what the NOI is. This is the amount of cash flow generated by an investment property after subtracting operating expenses, but before principal and interest payments, capital expenditures, depreciation and amortization.
The next step is to determine the property worth, which may be done by having a real estate agent do a comparative market study or having the property assessed. On sites like Zillow, you can also receive a ballpark estimate of how much your home is worth right now. The cap rate is then calculated by multiplying that value by 100. Although it varies by property type and region, a reasonable cap rate is often 4 to 7% or greater.
Example of a Cap Rate
Now that we know what the Formula for calculating the cap rate is, let’s look at an example. Let’s assume that we want to figure out the cap rate on an apartment building in an area that has average cap rates of 7 percent.
Assume that the apartment building’s NOI is $80,000 and that the property is valued $1.2 million.
We begin by multiplying the NOI by the property value.
0.067 = $80,000 / $1,200,000
Then we multiply by 100 to achieve a cap rate of 6.7 percent.
Now we can compare that cap rate to the average for apartment buildings in the region and determine if the NOI for that building is low, or we may offer a lower purchase price to get the cap rate closer to the area’s average of 8%.
How to Calculate the Return on Investment (ROI) on an Investment Property
An alternative or addition to calculating Returns on Cash Invested and cap rate, is calculating your ROI. Concerning real estate, ROI is your return on your total investment in the property. It includes both the cash you invested and any debt that you leveraged on the property including things like an investment property loan.
ROI differs from cap rate because it considers your mortgage payment in the formula. It also differs from Returns on Cash Invested because it takes into consideration, not just the cash you spent for the downpayment and lender fees but also the amount of money you financed.
ROI can be skewed because it appears as if your Investment Return on Investment is greater when you have a mortgage than if you paid using all cash. This is why it’s so important to use more than one way of analyzing an investment property before you purchase it.
Formula for Return on Investment
Return on Investment (ROI) = Annual Return / Total Investment x 100
To calculate their yearly return, investors deduct their property-related expenditures from their overall rental revenue to arrive at their NOI. Then you divide it by your entire investment, which is the amount of cash and debt you have in the property. After that, you double the result by 100. A decent return on investment property is often more than 10%, while a good return on a fix-and-flip is greater than 15%.
Example of a Return on Investment
Let’s take a look at an example of an investor using the Formula for Return on Investment to decide if they want to purchase a duplex.
Assume that the duplex’s yearly yield is $24,000 and that the total investment required to acquire the duplex is $150,000.
To calculate a percentage, divide the yearly return by the entire investment and multiply by 100.
$24,000 divided by $150,000 multiplied by 100 is a 16 percent return on investment.
The ratio of 16 percent is considered a strong return on investment for an income-producing property. Once you have the ROI, you can compare it to other ROIs on comparable properties in the region, as well as other investment possibilities, to see which will provide you with the best return.
How to Calculate Returns on Cash Invested on an Investment Property
Returns on Cash Invested measure the return on the actual cash invested into the investment property. It’s also referred to as the cash yield on an investment property. Investors who pay all cash for a property often use cash-on-cash return as a quick tool to see their rate of return.
Returns on Cash Invested can help investors prescreen a property. It’s also an easy way to compare properties based on a relatively simple calculation. This is in comparison to ROI, which is more complex and takes more time and more knowledge about the property.
The cash-on-cash return may be used to anticipate future cash dividends of an investment property in addition to calculating the present return. Keep in mind that this isn’t a guaranteed future return; rather, it’s a target future return and an estimate of what the property will generate in the future.
Returns on Cash Invested Formula
Annual Pretax Cash Flow / Actual Cash Invested x 100 = Cash-on-Cash Return
The cash-on-cash return formula is one of the most widely used and straightforward real estate investment methods. The yearly pretax cash flow divided by the actual amount invested multiplied by 100 is the cash-on-cash return.
You combine your gross scheduled rent plus any extra property generated revenue minus your vacancy minus operational expenditures to get your yearly pretax cash flow. You’ll need to know how to compute your real cash invested for the following portion of the calculation. This is done by totaling up all of the money you put into the property, including the down payment, closing expenses, and property repairs.
Returns on Cash Invested can be used in addition to cap rate and ROI to find out how well a rental property is performing, if it’s a good value and how the subject property compares to other properties. Typically, 8 to 12 percent is considered a good cash-on-cash return. Keep in mind, that this number is skewed if you finance the property, and you need to make sure you can afford the monthly mortgage payments.
Returns on Cash Invested Example
Consider the case of an investor deciding whether or not to buy a duplex based on the cash-on-cash return. Assume you know your total financial outlay is $75,000, which includes your down payment, closing charges, and rehab expenses. Let’s say your yearly pretax cash flow is $12,000 per year.
You double your yearly cash flow by 100 after dividing it by your total amount invested.
Return on investment: $12,000 / $75,000 x 100 = 16 percent cash-on-cash
Because this property has a high cash-on-cash return, it would most likely be an excellent investment. However, if you finance the property, you need consider the financing expenses as well as the cap rate and ROI.
Pro Tips on Using Cap Rate vs. ROI vs. Returns on Cash Invested Formula
Cap rate vs. ROI and the Returns on Cash Invested formula can get a little bit confusing when analyzing real estate. Remember, that we recommend using all three metrics as much as possible when figuring out the rate of return and performance of an income producing property.
Here, we have a few thoughts from the pros on Returns on Cash Invested and cap rate vs. ROI.
1. Compare similar properties using cap rates
When comparing cap rates amongst income-producing properties, investors must compare apples to apples. This implies they’ll have to compare property cap rates based on both the location and the property class. A duplex in the country, for example, should not be compared to an office building in a city.
“Investors may utilize cap rates to compare projects; however, it’s not always black and white. For example, in a top market, an investor’s cap rate may be lower, whereas in a submarket, it may be greater. As a result, although cap rates for each project may be compared, other aspects must be considered before making a choice.”
— Puja Talati, Enzo Multifamily’s Partner
2. Compare Real Estate Investments Using the Same Calculations
It doesn’t do you much good if you use different calculations on different properties and then compare them, expecting the results to help you make a purchase decision. It’s recommended to use the cap rate, ROI and Returns on Cash Invested for each property. However, if you only use one, make sure it’s the same one for each property you analyze and compare.
“I believe the most essential thing to remember when comparing investments is to make sure you’re using the same computation.” So, instead of comparing the ROI on one investment to the cash-on-cash return on another, look at the cash-on-cash return on both. Make sure you’re comparing the ROIs or the cash-on-cash returns of both.”
— Cornelius Charles, Dream Home Property Solutions, LLC, Co-Owner
3. Compare Properties Using a Combination of Investment Formulas
Cap rate, ROI and Returns on Cash Invested can each stand on their own when analyzing and comparing investment properties. However, the most accurate results come from using all three formulas.
“Cap rate and Returns on Cash Invested are both important metrics to consider when evaluating real estate investments. Both of these numbers are ways to determine the ROI of a real estate investment. Specific to multifamily, I suggest using a combination to evaluate any deal.”
— Veena Jetti, Enzo Multifamily’s Founding Partner
Frequently Asked Questions about Cap Rate vs. ROI (FAQs)
We’ll answer some of the most often asked questions about cap rate vs. ROI, how to calculate ROI, and the cash-on-cash return formula in the sections below.
What Is an Appropriate Cap Rate?
The kind of property, location, and net operating revenue all influence the cap rate. In general, investors want a cap rate of more than 4% for residential properties and more than 7% for commercial properties. A higher cap rate is preferable since it indicates that the property’s fair market value is low in comparison to the NOI.
What Is the Formula for Cash-on-Cash Returns?
The following cash-on-cash return formula is used by the majority of real estate investors: Your entire cash investment divided by your net operational income. As previously stated, net operating income is calculated by subtracting total running expenditures from prospective rental revenue + other income minus vacancy losses.
How to Calculate the Return on Investment (ROI) on a Fix-and-Flip Project
The Formula for Return on Investment is simply your annual return divided by your total cash investment. However, calculating the ROI for a fix-and-flip is difficult because you have to work backward to get the variables. These include the property’s acquisition, rehab and sales and marketing costs. To make this easier, check out our free house flipping calculator.
What Is a Cap Rate Calculator and How Does It Work?
A cap rate calculator is a tool that assists real estate investors in calculating the rate of return on their investment. Property valuation, gross yearly rental revenue, operational expenditures, and vacancy rate are among the inputs. The cap rate calculator will generate your capitalization rate when the investor fills in the information.
Final Thoughts
Real estate investors use different formulas to analyze how income-producing properties are performing and to make decisions on whether they should buy or lease commercial real estate. Investors often debate if they should use cap rate vs. ROI in their analyses. However, it’s typically best to use cap rate, ROI and Returns on Cash Invested to get a comprehensive financial picture of the property.
The “cash on cash return calculator” is a tool that uses the cap rate, ROI and cash-on-cash returns to find out how much your property will be worth in the future.
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