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Cap Rate: What It Is and How To Use It

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• Capitalization rate = Net operating income / Market value

• $12,000 NOI / $150,000 market value = .08 or 8% cap rate

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In this example, a real estate investor can expect to receive an annual return of 8% from a rental property worth $150,000. By rearranging the cap rate formula, investors can also determine what the NOI and fair market value of a property should be.

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Using the cap rate formula to calculate NOI

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• Cap rate = NOI / Market value

• NOI = Market value x cap rate

• $150,000 market value x 8% cap rate = $12,000 NOI

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Using the cap rate formula to calculate market value

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• Cap rate = NOI / Market value

• Market value = NOI / Cap rate

• $12,000 NOI / 8% cap rate = $150,000 market value

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What is a good cap rate?

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The answer to this question depends on if you’re buying or selling. For sellers, a lower cap rate means the sales price of the property will be higher. For buyers, a higher cap rate could mean a better deal.

The fact is that cap rates vary from market to market. Factors that affect market cap rates include:

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• Age of the property

• Neighborhood the property is located in

• Amenities and access to transportation

• Demand for rental property in the market

• Job and population growth in the market

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There are literally hundreds of properties in different markets across the U.S. You can compare cap rates, rents, total 5-year returns and more for single-family rental properties.

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Cash-on-Cash: What It Is and How to Use It

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Real estate investors use the cash-on-cash return formula to measure how quickly the amount of cash invested in a property will be returned to them. Cash-on-cash return is expressed as a percentage. The higher the percentage, the quicker the return on investment.

 

Cash-on-Cash Formula

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The cash-on-cash formula compares the net cash generated after paying normal operating expenses – including the mortgage -- to the amount of cash invested in the property:

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• Cash-on-cash return = Before tax cash flow (NOI – mortgage payment) / Total cash invested

• ($12,000 NOI - $7,200 mortgage payment) = $4,800 before tax cash flow / $37,500 total cash invested = 12.8% cash-on-cash return

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In this example we assumed the investor made a 25% down payment on the $150,000 rental property

($150,000 x .25 = $37,500) and had an annual mortgage payment of $7,200.

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The cash-on-cash return formula can also be used to calculate how much cash needs to be invested to achieve a targeted return, and how to obtain a specific before-tax cash flow. However, doing these calculations can be complex because the mortgage payment changes based on the amount of cash down.

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What is a good cash-on-cash return?

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Just as with our “What is a good cap rate?” question, there’s no right or wrong answer to what makes a good cash-on-cash return. Some single-family investors are happy with an 8% return on their cash invested, while others look for cash-on-cash returns in the double digits.

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However, as a single-family rental property investor, it’s important to realize that the amount of leverage on a property has a significant impact on the cash-on-cash return.

 

In other words, while the cap rate of a specific property is the same for every investor, cash-on-cash return varies from investor to investor.

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Key takeaways for cap rate vs. cash-on-cash return

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Cap rate compares the net operating income a rental property generates to the purchase price of the property. It provides an apples-to-apples comparison of similar properties in the same market. 

The return (or cap rate) of a specific property is the same for every investor. That’s because the mortgage payment isn’t included in the cap rate calculation.

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On the other hand, cash-on-cash measures the potential profit an investor can expect to make on total cash invested. Because cash-on-cash does include the mortgage payment, the same investment property can have different cash-on-cash returns based on different amounts of leverage.

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Finally, there’s no right or wrong answer to “What is a good cap rate?” or “What is a good cash-on-cash return?”. The answer really depends on each investor’s unique goals and investment strategy

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For More information about financing your next real estate project,  call us at 800-805-3391