Cap Rate Vs Cash on Cash Return.
Cap Rate: What It Is and How To Use It
Capitalization rate = Net operating income / Market value
$12,000 NOI / $150,000 market value = .08 or 8% cap rate
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.
Using the cap rate formula to calculate NOI
Cap rate = NOI / Market value
NOI = Market value x cap rate
$150,000 market value x 8% cap rate = $12,000 NOI
Using the cap rate formula to calculate market value
Cap rate = NOI / Market value
Market value = NOI / Cap rate
$12,000 NOI / 8% cap rate = $150,000 market value
What is a good cap rate?
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:
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
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.
Cash-on-Cash: What It Is and How to Use It
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.
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:
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
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.
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.
What is a good cash-on-cash return?
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.
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.
Key takeaways for cap rate vs. cash-on-cash return
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.
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.
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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Outlook for the rental property market is strong, the demand for housing is increasing and more people are choosing to rent rather than own. While the demand from tenants for single-family rental property is growing, real estate investors should realize that not all rental property is created equal. Two of the most important metrics used to analyze the financial performance of income property are the cap rate and cash-on-cash formulas.