[summary]Are you confused about the terms “Cap Rate” and “Cash on Cash Return?” This post will explain everything.[/summary]
There are several means of determining the return on an investment property.
You may hear the term “ROI” (or “ROR”), which means “Return on Investment” (or “Rate of Return”), which can be calculated in all sorts of ways.
Unfortunately, a lot of people will determine this number based on whatever factors will yield the highest number, regardless of how accurate to real-life it might be.
ROI is very general and encompasses your overall return on investment and it includes a lot of estimates and unproven numbers.
Less generically, a Cap Rate is most often given for a property.This term more specifically relates the sales price of the property to the income it generates. It more or less tells you if you are buying an investment property at a good price.
If you are buying too high, this will be reflected with a lower-than-normal Cap Rate. Or reversing the scenario, sometimes a Cap Rate will guide someone on how much to sell their property for.
If there aren’t a lot of comparables in the area to base a selling price off of but the going market Cap Rate is say 7%, the seller can figure out what sales price would yield a 7% Cap Rate.
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 actual money you put in.
So, in terms of an actual return on your money, you want to focus on the CoC Return and not the Cap Rate.
The Cap Rate really only matters when you sale or buy a property, unless it’s a case where you are paying all cash. If that happens, the CoC will calculate out to be the same as the Cap Rate, which is why these two are related and why I’m talking about them together and explaining how to differentiate them.
You are more likely to see a Cap Rate of a property advertised rather than a CoC for two reasons:
1. When a property is listed, i.e. for sale, remember that is when the Cap Rates matter- during a sale. It is a method of showing you the (supposed) property’s worth in comparison with the income that it generates.
2. Assuming a financed property, CoC can vary per buyer because it is dependent on the financing terms used to buy the property. So one person’s CoC might be different than another person’s CoC for the same property.
Although they are unlikely to vary that much due to interest rates (those only vary minimally in the same time period) it is more likely to vary depending on how big of a down payment a buyer puts down.
Essentially, it will differ depending on what the monthly mortgage expense is which differs depending on the buyer’s qualifications, the interest rate, and the down payment.
Purpose and Calculation of a Cap Rate:
Cap Rate is short for Capitalization Rate.
Investopedia defines Capitalization Rate (we just call it Cap Rate for short) as:
A rate of return on a real estate investment property based on the expected income that the property will generate.
The Cap Rate is really, in my experience, the one number that you will see listed for almost all investment properties (unless it’s a property that isn’t listed specifically as an investment, in which case, you are likely to immediately calculate the Cap Rate to determine if the property is worth pursuing).
There is debate as to whether a Cap Rate is applicable for single-family properties, versus multi-family or commercial properties, but I use Cap Rates for all properties.
The reason for the debate is that commercial properties are almost always priced based on Cap Rate, whereas residential properties can’t necessarily be priced just on Cap Rate because they have to take into consideration market value.
The debate doesn’t matter for the purpose of this article though, so that’s as far as I’m going to get into that.
How do you calculate the cap rate of a property?
Annual Income / Purchase Price = Cap Rate
If you look at the equation on Investopedia, it actually uses “Total Value” in place of “Purchase Price” and it gives an example about how a Cap Rate changes as the value of a house changes.
This is true, it does change with a change in value, but I’m very strict in reminding people that the value of a house doesn’t matter unless you are trying to buy or sell it.
So, calculating an updated Cap Rate is really pointless unless you are thinking of buying or selling, hence why I use “Purchase Price” instead. To each their own on that one, but anytime I’ve calculated a Cap Rate, it’s been based off of the price of the property as it is listed (for sale).
Back to the equation, I’ll write it out with a little bit more detail just so it’s clear:
((Monthly Income * 12) / Purchase Price)*100 = Cap Rate
Often you will know the monthly income rather than the annual income, so just multiply that number by 12 (months) to get the annual income. Then multiply all of it by 100 to convert the resultant number into the actual percentage. So for example you might calculate 0.987 as your answer, so converting that to a percentage gives a 9.87% Cap Rate.
NOTE: The income you use for this calculation, as with all calculations should be your NET Income. Your Net Income is the income you receive after all expenses are paid.
This is different than the GROSS Income you receive, which is the total amount in rents you collect prior to paying expenses. Using a Gross Income in these calculations will give you a completely inaccurate (i.e. unrealistic) result.
NOTE: As with all calculations, know exactly what numbers you are using to calculate your Net Income. Don’t be conservative with expenses, don’t use estimated values when you don’t need to and be sure to include vacancy and repair estimates (you do actually have to use estimates for those).
Anytime you see a Cap Rate or any calculation of return, make sure you either know or you question what numbers were included to determine that number. People love to make returns better than they really are, so don’t get tricked into thinking a return is excellent because you don’t know if they really even used realistic numbers in determining it.
Once you have the Cap Rate how do you know if it is a good Cap Rate or not, or in other words, how do you know if this property is a good investment property or not?
Well, it depends on where the property is located and what is is happening in the general real estate economy.
Different cities have different Cap Rates and different areas within cities have different Cap Rates, and what is a good Cap Rate in those areas today, may be totally different than what they have been in the past.
So, you have to be familiar with the market in which you are buying to know what a “good” Cap Rate would be.
You also have to consider the type of property you are buying and the growth potential of that property (and market) because those factors will affect the overall ‘market’ Cap Rate that should be expected.
For more details on varying Cap Rates and what to look at, check out: Battle of the Cap Rates.
Purpose and Calculation of a Cash-on-Cash Return:
Investopedia defines a Cash-on-Cash (CoC) return as:
The cash income on the cash invested.
The CoC is a more accurate calculation of the return you will get on the money you invest. As previously stated, (but worth the reminder) the CoC for an all-cash purchase will be the same as the Cap Rate.
But assuming you are financing, the return you are getting on the actual money you invest is different because you aren’t putting down the full price of the property, you are only putting down a % of the total price. So you don’t want to use the Purchase Price in the equation, you instead want to use the amount you paid.
Annual Income / Cash Invested = Cash-on-Cash Return
The same rules apply here as far as using Net Income (not Gross), multiplying the income by 12 if you only know the monthly income, and multiplying the whole result by 100 to create a percentage format rather than decimal.
The Trickiest Difference between a Cap Rate and a Cash-on-Cash Calculation:
The biggest difference between the two calculations is the number you use in the denominator of the equation, it being either the Purchase Price or the actual Cash Invested.
Definitely don’t forget the difference there!
There is also a less obvious difference though, that trips people up just about every single time they try to calculate these two numbers.
Cap Rates are not calculated with the financing cost included as an expense.
Cash-on-Cash Returns are calculated with the financing cost included as an expense.
In order to calculate your Net Income, you have to subtract all of your expenses from the gross income.
If you are financing a property, one of your expenses is financing (most often a mortgage payment, so I’ll call it the mortgage expense but it pertains to any type of financing).
If you are financing a property, that’s great, but you have to keep that mortgage payment out of your expenses list to determine the Cap Rate.
A Cap Rate has nothing to with financing or the result of financing, so it cannot be included in calculating an accurate Cap Rate.
On the other hand, since a CoC specifically calculates the actual return on the money you put in, you do include the mortgage payment in your expenses for this calculation.
I guarantee you, no question, that you will forget this (often) and miscalculate. I’d say 80% of the miscalculations I’ve seen by investors when determining both of these numbers is because they misplaced that mortgage payment in the equations.
I can’t give you an easy way to remember not to mess up with that but if you calculate a number with either equation that doesn’t seem quite right, you might as well default to checking to see if you put that mortgage payment in the wrong place. I can’t say this enough-
Cap Rates do not involve financing in any way, not even a mortgage cost.
Cash-on-Cash Returns do involve financing because the return itself is completely dependent on financing, so the mortgage cost must be included.
It may seem complicated, when and how to use these numbers, but it’s really not once you get in the swing of using them.
If you decide you only want to care about one number though, be sure it’s the CoC and not the Cap Rate.
The CoC is the actual return on your money which is what ultimately matters in the investing world.
In the case you buy all-cash, this will be the same as the Cap Rate anyway.
To see better how both of these are calculated, in a real-world scenario, check out Rental Property Numbers so Easy You Can Calculate Them on a Napkin and you will get a better big-picture view of using these numbers.
And you didn’t think all that math we learned in school was going to apply to real life!
Welcome to real estate!
Oh, and as a last note, don’t ever buy an investment property (for cash flow at least) without knowing these values. Even with knowing them there is room for error, so be conservative with them and leave some margin for profit!