For most real estate investors, the point of a commercial real estate investment is to earn a return on their capital. But, in order to know what the return is, there has to be a way to measure it.
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. To learn more about our current investment opportunities, click here.
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. To learn more about the cap rate, click here for a detailed post.
The property’s valuation is a bit more tricky. It can be represented by the purchase price, appraisal, or value estimate.
As it relates specifically to this post, cap rates 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.
The 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 cash on cash return is 10%. This may sound very similar to the cap rate, but there are several important distinctions.
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. For example, if a property had $100,000 in NOI and $60,000 in debt service, the numerator in the cap rate calculation would be $100,000 (NOI) and the numerator in the CoC return calculation would be $40,000 (money left after debt service).
- 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 These Metrics
When to Use The Cap Rate
There are two points in the real estate investing life cycle for which the cap rate is most useful.
The first point is in the property discovery/underwriting phase. In this phase, the cap rate can be used as a screen to filter out deals that don’t meet an investor’s return criteria. And, it can be applied to the property’s stabilized net operating income (NOI) to determine a fair purchase price for the property.
The second point is at the end of the holding period when the property is going to be sold. At this point, the cap rate is useful to determine the potential sales price. Sometimes, this is referred to as the “terminal cap rate” and it is applied to the final year of net operating income.
When to Use the Cash on Cash Return
The cash on cash return is also useful as a screen to filter out deals based on annual return on investment requirements. But, it is also useful on a year to year basis to gauge how the property’s performance is tracking with original estimates.
For example, suppose that the original pro forma projections estimated a 7% annual cash on cash return. But the actual cash on cash return was 5% in year 1. With this knowledge, an investor could proactively take action to get back on track. Perhaps they could look for some way to cut operational costs in an effort to increase the cash available after debt service.
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.
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 seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.