Investment Calculation

2 Replies

From what I know cap rate is calculated as NOI/Value of Asset (Down payment+amount financed). While the cap rate seems like an OK calculation, it does not include the part you pay for financing so it is possible to have a positive cap rate with negative cash flow.

Would a another useful calculation be your total net income/value of asset? It seems like this would be good since it looks at the whole picture while cap rate calculation only looks at part of the picture. 

Is this calculation commonly used? If so what is called?

If it is not used, why?

To your 1st question:

Yes you can have positive cap with negative cash flow.  Cap are usually dealing with leased investments.  If trying to secure a loan for a leased investment, the lender will want a debt cover ratio >1, so technically, going the conventional loan route, this may never happen.  However, if you get into "creative financing", then yes you can most certainly have negative cash flow.

To your 2nd question:

I'm assuming when you say total net income, you mean NOI - interest payment - depreciation - taxes.

In business, this ratio is known as Return on Asset, so yes there is such a ratio. However in real estate, it's not commonly used. Part of the reason is that some investor's goal in real estate is to get a negative net income with depreciation (with positive cash flow), which renders the ratio a negative number and hence useless. More commonly however, it's not used in RE just because of tradition. For instance "NOI" in real estate is the same as "EBITDA" in business. And "cash on cash" is a ratio only used in real estate, it does not exist in the business world.

Keep in mind you can use whatever ratio works for you.  I personally hate the cash on cash ratio and never use it.  There's not a need to follow the crowd.  However, if you want to communicate with other and compare, you need to use a common ratio.

Don't forget to include up front capital expenses in your cap rate. But overall a cap rate is to judge how good a property is on it's own, so it's basically measuring what return you will get with no loan. In other words, cap rates disregard the financing and look soley at the quality of the asset as an investment. It doesn't punish you based on how you finance the deal.

To add financing in, you want two numbers: cash flow and cash on cash:

Cash flow = NOI - Debt Service

Cash on Cash = Cash Flow / Cash Into Deal 

You can also look at debt service ratios, which banks look at a lot to see what ratio your income is compared to your debt service (most banks look for at least a 1.2):

Debt Service Ratio: NOI / Annual Debt Service

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