When getting into real estate, investors quickly find a world of challenges, including the many metrics used when evaluating deals and making decisions. What metrics to use and how and when to use them can become challenging and burdensome.
I will go into detail on two of arguably the most important metrics: Capitalization (CAP) Rate and Cash-on-Cash Return. Although both talk to the performance of the asset, there are major differences. Both should be considered when purchasing a property but in different ways.
The CAP Rate is used to determine the un-leveraged rate of return on a property, i.e., the return if the property was purchased in cash and no loan was taken out.
So, in order to calculate the CAP Rate, the Net Operating Income (NOI) is required. To find this, the property’s expected rents and other income and all projected operating expenses associated with the property is required. The NOI calculation is illustrated below:
Note that NOI excludes principal and interest payments on loans, capital expenditures, depreciation, and amortization. All other expenses directly related to a property should be considered.
A CAP Rate is best used to value a property. Comparing CAP Rates in certain areas can give investors insight into what the property is worth and, more importantly, what they should pay for it.
A property is listed for $1,000,000. An investor has done their homework and discovered the NOI is $100,000, equaling a 10% CAP Rate ($100,000/$1,000,000). However, upon further research, properties in the area typically sell at a 12% CAP Rate. Knowing this, the investor reverse engineers the calculation to decide what they should pay given the 12% market standard. By dividing the NOI by the market standard CAP Rate, the investor decides to put in an offer of $833,333 ($100,000/12%). Moreover, let’s assume the investor knows that the $100,000 NOI is such due to below market rents and high vacancy. They know that market rents at 90% occupancy for the subject asset should add $20,000 more to the NOI. Given the 12% CAP Rate for the area, when vacancy is reduced and rents are increased, the investor will have brought the value of the property up to $1,000,000 ($120,000/12%).
In this example, you can see how useful a CAP Rate is in comparing properties. CAP Rates vary from market to market determined by demand and other factors. Knowing the standard in their markets allows investors to make educated, calculated offers.
One of the great advantages of investing in real estate is leverage! Banks see lending on real estate as a relatively low-risk loan because it is backed by a real asset. If the investor doesn’t pay, the bank can foreclose on the property. Because of this, investors can generally put 25% or less of the purchase price down to secure the property. The cash-on-cash return measures the rate of return on the cash invested based on the cash flow the property generates. Cash flow differs from NOI in that it also factors the principal and interest payments on loans. The calculation is as follows:
Investors see Cash-on-Cash Return as a valuable metric because it shows the liquid rate of return on their total cash invested. I use the term liquid because it doesn’t factor in property appreciation and loan pay-down – a return that has no effect on cash until the investor sells or refinances.
An investor has pinpointed a property they are interested in purchasing. They now want to determine the Cash-on-Cash Return this property will generate so they can compare to other investments they will be forgoing by making this purchase. They are approved to finance at 75% loan-to-value at a 5% interest rate. The numbers are as follows:
In this example, the total cash out of pocket for the investor is $29,000 while the total annual cash flow generated from the purchase is $2,698.56. This means the Cash-on-Cash Return is 9.3% ($2,698.56/$29,000). The CAP Rate for the same example is 8.3% ($8,280/$100,000) as it excludes principal, interest, and capital expenditures in the expense calculation and uses the asset purchase price as the basis.
It is important to note that the Cash-on-Cash Return will increase the less cash the investor has to put down, assuming a favorable interest rate.
To illustrate, assume the investor was able to secure a loan with a 5% down payment. At the same 5% interest rate, the upfront cash required changes to $9,000 and the principle and interest expense changes to $6,119.76. While the annual cash flow decreases to $1,410.24 due to the increase in principal and interest payment, the Cash-on-Cash Return increases to 15.7% ($1,410.24/$9,000) due to the lower down payment. This speaks to the argument of whether to leverage as much as possible or pay down loans, but that discussion is for another day!
In summary, both the CAP Rate and Cash-on-Cash Return are valuable metrics in real estate but should be used for different purposes. The CAP Rate allows investors to quickly value properties and compare markets. The Cash-on-Cash Return shows investors their liquid return on cash invested and allows investors to see what their deployment of cash is giving them back which allows them to compare not only to other real estate purchases but alternative asset class investments that they will be forgoing by making the purchase.
Real estate can truly be an exceptional wealth-building investment. It is important to use the best tools at hand to make the wisest decisions possible!
Got any questions? Shoot me an email at firstname.lastname@example.org or click here to schedule a free phone consultation.