Cap Rate vs. Cash on Cash Return
Real estate investors are always trying to measure the rate of return (ROI) as part of an investment property analysis. However, ROI has become a more broad term to be used in real estate. Today, we’re exploring two more specific terms or tools to measure ROI for an investment property — the cap rate and CoC return.
What is Cap Rate?
Cap rate, short for capitalization rate, is a measure of profitability of a real estate investment. More simply, it is how much of the value of the property is an investor receiving as profits. Cap rate can be a measure of how risky an investment is. The higher the cap rate, the higher the level of risk, and the higher the prospected profitability. Simple finance. And the lower the cap rate, the lower risk there is, the lower thhe prospected profitability.
How is cap rate calculated?
You can calculate the cap rate by dividing the net operating income (NOI) of an investment by the price of a property (market value). The formula would be as follows:
Cap Rate = Net Operating Income / Purchase Price
*NOI = annual rental income — operating expenses.
For example, suppose you have a property with an NOI equal to $130,000 and a selling price equal to $1,000,000. The cap rate will be calculated as follows:
Cap rate = $130,000 / $1,000,000
Cap rate = 0.13 = 13%
Uses of Cap Rate
Cap rates are very useful because they help an investor or a home buyer to compare different investment opportunities, and accordingly decide whether or not an investment is worthwhile. Many investors set a minimum cap rate percentage to “accept” when investing in a property. This helps them realize which properties are good investments and which ones are not.
You can also use the cap rate to check how an investment is doing over a period of time and whether or not it’s improving. If you see that the cap rate is increasing, this is a good sign. The opposite holds true; if cap rate is declining, it may be time to rethink your investment.
Finally, the cap rate can be used to estimate the selling price of a property. If you know the cap rate of comparable properties and net operating income, you can plug in the value and find out an estimated selling price for your property.
What is Cash on Cash (CoC) Return?
CoC return is another real estate tool which measures the relationship between cash invested and the cash flow, or net operating income of a property. CoC return measures the annual return on investment.
How is CoC return calculated?
The formula for CoC return is as shown below:
CoC Return: Annual Net Operating Income / Total Cash Investment
For example, suppose your annual net cash flow for the year for your property was $15,000, and that that you’ve put down a $60,000 as a down payment for the property. Your CoC return would be calculated as follows:
CoC Return = $15,000 / $60,000
CoC Return = 0.25 = 25%
Uses of CoC Return
CoC return is an indicator of an investment’s performance; that is, how well an investment is doing. CoC can also be a way to forecast future cash flow returns on the property. CoC, very much like cap rates, can be used to evaluate how an investment is doing and whether it’s improving or not.
Related: What is a Good Cash on Cash Return?
Cap Rate vs. CoC Return
It’s important to mention that if you purchase a property with all cash, the value of CoC will be the same as the value of the cap Rate. To understand, go back to the denominator in each formula. If you do not use a loan or put down a down payment, if you pay in cash at the time of the purchase, then both denominators will be equal to the price of the property (investment), and there will be no difference between cap rate and CoC return.
So where does cap rate differ from CoC return?
There are three main differences between cap rate and CoC return.
- If you do not purchase in all cash, the denominator in each equation will be different. It will be purchase price in cap rate calculation, and cash investment for CoC return.
- While CoC return considers the annual financing costs for the property, also identified as the annual investment, cap rates do not. So when calculating cap rate, you should never include any financing costs such as mortgage cost.
- Financing costs are included as an expense in the calculations of CoC return, but they are not in the calculation for cap rate.
How Mashvisor Can Help
If you try to search for a city on Mashvisor, you’ll get thousands of listings to look at. What’s great about the site’s investment analytics is the fact that it provides information such as expected rental return, Airbnb occupancy rates, as well as cap rate and CoC return for single properties, and neighborhood and city averages. Based on the data, you can decide which cities have higher values for cap rate, as well as other indicators. Mashvisor’s features will help you in browsing, comparing, and selecting the best property among several types of investments.
Originally published at www.mashvisor.com on February 28, 2017.