In this article, we will discuss two common real estate metrics that are used to measure commercial real estate investment returns, the cap rate and the cash on cash return. We will describe what they are, how they are calculated, and why they are important. By the end, readers will have a more nuanced understanding of these important metrics and should be able to calculate them for their own real estate investment opportunities.
At First National Realty Partners, we always calculate the cap rate and cash on cash return as part of the pre-purchase due diligence for all of our investments. As part of this process, we eliminate many deals and only bring the most promising options to our investors.
The Cap Rate Explained
The capitalization rate, or “cap rate” for short, is a real estate metric that is used to describe the relationship between a commercial property’s Net Operating Income (NOI) and its purchase price/market value. Mathematically, it represents the expected annual rate of return, assuming a property was purchased with cash.
Calculating the Cap Rate
The formula used in the cap rate calculation is:
Cap Rate = Net Operating Income / Property Value
In this equation, real estate investors can calculate Net Operating Income by subtracting a property’s operating expenses from total income. The result provides some insight into the property’s operational efficiency.
The property’s valuation is a bit more tricky. It can be represented by the purchase price, appraisal, or value estimate. Because these inputs are not always known, commercial real estate investors often use the principle that if two of the three variables (NOI, cap rate, property value) are known, the missing one can be solved for. This flexibility is a major reason the metric is widely used in underwriting.
Interpreting Cap Rates
Cap rates can also represent a real estate market’s assessment of risk associated with the purchase of a property. A lower cap rate means that the property is judged to have less risk, which usually means slow, steady growth in net operating income. Traditionally, property types like multifamily or those with strong tenants tend to fetch the lowest cap rates (highest price).
A higher cap rate means that the market judges the property to have more risk, which means that investors need to earn a higher rate of return to purchase it. As a result, the price will be lower. Properties in riskier asset classes like hotels, restaurants, and office buildings or those that have large vacancies or operational issues tend to fetch higher cap rates.
Benefits of Using Cap Rate
There are three key advantages to using the cap rate as a measure of return on a real estate investment.
- It is easy to calculate and the inputs needed are either readily available or can be estimated with ease. This also allows for a simple way to compare potential returns across property types and asset classes.
- It provides some insight into the potential return on a property. In fact, the resulting percentage represents what a real estate investor could earn if they purchased the property with cash. If debt is used in the purchase, the return would be higher than the cap rate.
- Because there is an inverse relationship between risk and return, the cap rate is also a quick way to gauge the market’s assessment of risk in a property. But, it is important to remember that cap rates are unique to each deal.
Because the cap rate represents an annual return on investment, it is often compared to another return metric: the Cash on Cash (CoC) return.
Cash on Cash Return Explained
Whereas the Cap Rate provides an indication of a property’s annual return assuming an all cash purchase, the Cash on Cash return provides an indication of an investor’s return based on the amount of cash invested.
Calculating the Cash on Cash Return
The formula for cash on cash return is:
Cash on Cash Return = Annual Cash Flow (net of Debt Service) / Total Cash Invested
The cash received in any given year is represented by the amount of money left after all of an investment property’s operating expenses and debt service have been paid. The total cash invested is represented by the total capital invested in a deal. For example, if a rental property produces $10,000 in annual cash flow on a $100,000 investment, the CoC return is 10%.
There are two varieties of CoC:
- Unlevered cash on cash return, which excludes the impact of debt
- Levered version, which incorporates the effect of financing. The levered version is generally higher because it reflects the use of borrowed capital.
Advantages of The Cash on Cash Return
Like the cap rate, the cash on cash return is also easy to calculate with widely available inputs. But, the primary benefit of using this metric is that it provides a more realistic picture of the property’s financial performance because it accounts for the impact of the leverage used in the transaction.
For properties that carry higher risk, it would be expected that they would also come with a higher cash on cash return. Likewise, a lower cash on cash return would be expected for a property that has less risk.
Differences between the Cap Rate and the Cash on Cash Return
Although both real estate metrics deal with a property’s income, there are three important differences between the cap rate and the CoC return:
Debt Service: The cap rate is calculated using net operating income, which is a metric that is calculated before debt service. The CoC return is a metric that is calculated with cash flow after the cost of debt service has been deducted. This is also where the difference between unlevered and levered returns becomes most apparent.
Sales Price: The cap rate formula uses a property’s sales price/market value in the denominator while the CoC return formula uses the total cash invested. If the property is purchased with cash, these numbers may be the same. Otherwise, the total cash invested typically represents the down payment on a property, net of debt.
Timing: The cap rate is typically calculated based on a property’s year 1, stabilized, net operating income. The CoC return is an annual figure.
Given these differences, there are specific times in the transaction lifecycle for which these respective metrics are most useful.
When to Use Each
When comparing the cap rate to the cash on cash return, neither one is an objectively “better” way of measuring real estate investment returns. They are just different and they have different utility in different circumstances. To be clear, they should both be used when evaluating a potential real estate investment opportunity, just at different times.
When to Use Cap Rate
The cap rate can be a helpful way to screen deals. For example, if a commercial real estate investor requires a cap rate of 8% or higher, they could quickly screen out any deal with a cap rate below that. This type of screen can prevent real estate investors from wasting time evaluating deals that don’t meet their return criteria.
When to Use Cash on Cash Return
For the remaining deals, the cash on cash return is a more detailed measurement of potential profitability. While a “good” return is different for every investor, 8% to 15% levered cash on cash return is usually considered acceptable. But, this is also measured relative to the “risk free rate”, which is the interest rate paid on a 10-year US Treasury bill. As such, a real estate investor may not necessarily be looking for an objective return, but a spread over the risk free rate.
When to Use Both Metrics
In reality, the best real estate investors use both of these metrics in every deal. In fact, they are typically used in conjunction with an entire suite of return metrics that include things like the internal rate of return (IRR), equity multiple, gross rent multiplier, operating expense ratio, and the debt yield. Additional tools such as the Debt Service Coverage Ratio (DSCR) can also serve as important measures of financial health and loan viability.
Each of these metrics, cap rate and cash on cash return included, have a slightly different purpose and provide slightly different information about the potential investment returns. So, by calculating and reviewing all of them, investors have a fuller picture of the risk and return in a particular deal.
Summary & Conclusion
The cap rate is a metric that provides information about the relationship between a property’s net operating income and its value. It is calculated as Net Operating Income divided by the market value of the property.
The cash on cash return is a metric that measures the annual return on the total cash investment. It is calculated as annual cash flow after debt service divided by the total cash investment.
Although they perform a similar function, there are important differences between these two metrics including how they are calculated and when they are used.
In practice, both of these metrics should be used in conjunction with a handful of other metrics to get a full picture of an investment’s risk/return profile.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we aim to identify investments that have the potential to deliver attractive long-term, risk-adjusted returns for our accredited investors while creating strong economic assets for the communities we invest in.
