Quick Summary – Cap Rate vs. Cash on Cash return

Income real estate investors often rely on these two main metrics to understand the price and value of a rental investment property.  Let’s look at table comparing CAP Rate vs Cash on Cash Return.  

CONTENTS

• What is CAP Rate?
  • How to Calculate CAP Rate
  • When to Use and When Not to Use CAP Rates
  • What is a Good Cap Rate for Real Estate Investing
  • CAP Rate Practical Examples
• What is Cash on Cash Return?
  • How to Calculate Cash on Cash Return
  • How and When to Use Cash on Cash Return
  • What is a Good Cash on Cash Return for Real Estate Investing?
  • The Power of and Danger of Financing Leverage
  • Cash on Cash Return Example
• Related Questions
  • Is CAP Rate the Same as Cash on Cash Return?
  • Is Lower or higher CAP rate better?
  • How Much Cash Flow is Good for a Real Estate Rental Property?
• Investment Opportunity

“Price is what you pay, value is what you get.”

Warren Buffet

What is CAP Rate?

The capitalization rate is a function of income as a percentage of asset value. The CAP rates of investment properties are often provided with the for-sale listings.  However, the listing information may be misleading.  Thus, investors must ask for actual accounting information to determine the real CAP rates.

How to Calculate CAP Rate

The formula for cap rate is as follows:

CAP Rate = Net Operating Income / Current Market Value of the Property

Net Operating Income (NOI) is equal to all the revenue from the investment property minus all the expenses related to the investment.  The NOI can be found in the property’s Profit and Loss (P&L) statement. 

When to Use and When Not to Use CAP Rates

CAP rates are used to compare similar properties.  If an investor is looking for an investment property and his focus is on properties with similar characteristics (i.e. location, asset class, property type, condition, etc), then the investor can easily use CAP rates to compare multiple properties. 

However, if an investor is comparing a luxury apartment complex to a mobile home park, then using CAP rates to evaluate which investment makes more sense is useless.  This is because CAP rates are affected by multiple factors.

What is a Good Cap Rate for Real Estate Investing?

In general, CAP rates are lower for properties in high appreciation markets.  Conversely, CAP rates tend to be higher for properties in low appreciation markets. 

To know what a good cap rate is, it is necessary to be familiar with the going CAP rates in the specific market area.  A 5% Cap rate may be a great investment in Denver, CO.  On the other hand, a 15% CAP rate may be a terrible investment in Flint MI.   

Without knowing the details, it would be impossible to know which is a better deal.  This is why CAP rates are only useful when comparing similar properties.  

If you are familiar with stock investing, you know stock investors use PE ratios to compare stocks.  Like CAP rates, PE ratios also measure the relationship between income and price. The difference is PE ratios have the price component on the nominator (Price divided by Earnings), whereas CAP rates have the price component on the bottom (Income divided by Price).

When using PE ratios to compare stocks investors always compare similar stocks.  It wouldn’t make sense to compare the PE ratio of Tesla to the PE ratio of Coca-Cola. 

In addition, beware of outlying CAP rates.  If the CAP rate range for similar properties falls between 5% and 7%, then be cautious if you come across a property that has a 10% CAP rate.  It may very well be this “cheaper” property can’t sell at the going CAP rates for a reason.

CAP Rate Practical Examples from Denver, CO.

Below is a screenshot from loopnet.com, filtered for low-rise multifamily properties for sale in Denver, CO.  As you can see the top two properties are advertised for the exact same price of $1,100,000.  And both properties are 6-unit apartment buildings. 

Looking at cap rates alone, it appears the first property is a better investment.  The first property has an advertised CAP rate of 5.20%.  The second property has an advertised CAP rate of 4.45%.

When you click on the either property you can see additional listing information, including Profit and Loss (P&L) information.  From here we can see the Net Operating Income (NOI) of the first property is advertised at $57,180 per year. 

Evaluating the CAP Rate for Denver Property 1

To calculate the CAP rate of this property we take the NOI divided by the price. 

Property 1 CAP Rate = $57,180 / $1,100,000 = 5.25%

However, there are a few important considerations.  First, immediately above the advertised NOI number you can see the word ‘Proforma.’  Proforma means the financial information provided here is based on certain assumptions and projections. In other words, the CAP rate shown here is NOT based actual income and expenses. 

Second, the advertised price is NOT the market value of the property. This is just the listing price, which is subject to negotiation.

Let’s assume last year’s NOI for this property is $47,000, instead of $57,180.  Then the investor would be paying a CAP rate of 4.3%, assuming a purchase price of $1,100,000. 

Property 1 Revised CAP Rate = $47,000 / $1,100,000 = 4.3%

Given this information, the investor may insist on a 5.2% CAP rate based on the actual NOI of $47,000.  In this case, the investor could offer $903,846 for the property.  That is $47,000 divided by 0.052. 

Property 1 Offer Price = $47,000 / 5.2% = $903,846.

Evaluating the CAP Rate for Denver Property 2

The same analysis can be performed on property 2.  One interesting thing is the listing for this property has a lot more information.  It appears that the 4.45% CAP advertised in Loopnet.com is based on the current year.  The image above shows a NOI of $48,938. 

A keen investor would certainly be aware of both properties.  This investor could approach the seller of property 2 and offer to pay the same amount he is willing to pay to the seller of property 1, that is $903,846, instead of the listed price of $1,100,000

What would be the cap rate of Property 2 at the offer price?

Property 2 Revised CAP Rate = $48,938 / $903,846 = 5.41%

Coincidentally, the forecasted CAP rates provided in the listing for Property 1 show a CAP rate of exactly 5.4% for year 1.  To be clear, this is a completely random coincidence, but this kind of tells me an offer of $903,846 could very well be within an acceptable range. 

These two properties are very similar in many ways.  Determining which property is the better deal could come to the terms of the contract.  One seller may be more flexible than the other.  And this is where the next real estate metric, Cash on Cash Return, comes into play. 

But, before we move on, I wanted to highlight that the information provided for Property 2 also includes some comps (comparable sales information), for the Denver area.  Here you can see three other similar properties that sold for higher cap rates. 

There are other sources for getting familiar with CAP Rates in a given market. See also Cap Rate for Real Estate properties Class A, B, C in the 100 Largest Cities in the USA

Again, all this information provides additional points of reference. 

What is Cash on Cash Return? 

Cash on Cash Return represents income (after debt service) as a percentage of total cash invested.  Note this metric doesn’t utilize the market value of the property, but rather, the cash out of pocket. 

Like CAP rates, COC values are usually provided along other information with for-sale listings, which must be scrutinized and validated. 

How to Calculate Cash on Cash Return

Technically speaking, the formula for cap rate is as follows is the Annual Before Tax Cash Flow divided by the Total Cash Invested.  For practical purpose, in this website we will assume Annual Before Tax Cash Flow is the same as the Net Operating Income minus Debt Service. 

COC = (Net Operating Income – Debt Service) / Total Cash Invested

Debt Service is the annual total amount paid to cover financing of the property. 

How and When to Use Cash on Cash Return

Cash on Cash Return is useful when evaluating an investment property that requires some form of financing.  For the average investor, financing is the norm.

Earlier we saw that CAP rates are used as a point of reference between properties.  The Cash on Cash Return provides more than just a point of reference. COC is similar to a return on investment calculation, but purely based on cash. As the term implies Cash on Cash represents how much cash a buyer can get from the initial cash investment.

For this reason, most income real estate investors are more concerned with Cash on Cash than CAP Rates.     

What is a Good Cash on Cash Return for Real Estate Investing?

Investors focused on portfolio growth rely on financing leverage to acquire real estate assets.  In other words, they want to buy as many real estate assets as they can, with as little cash out of pocket as possible.  These investors will generally be looking for the highest Cash on Cash returns they can get.

On the other hand, investors focused on cash flow will tend to minimize financing leverage.  These investors are willing to pay larger down payments to purchase real estate assets, provided they get the cash flow they want. 

My immediate investment objective is to grow my real estate portfolio.  When I look for an investment property, I am looking for 20% Cash on Cash Returns, or better.  But I may be persuaded to accept something lower if the property has other desirable characteristics (i.e. great location, upside potential, etc.)

A COC return of 20% and higher is possible when creative financing alternatives are on the table.  Most often, such alternatives involve some form of owner financing (seller financing). 

Consider that the Total Cash Invested part of the equation is in the denominator of the Cash on Cash formula.  Because of this, an investor making just $1 a year on a 0% down investment is getting an infinite Cash on Cash return.

The Power and Danger of Financing Leverage

Financing leverage can be a great tool.  In theory, an investor can buy real estate worth millions of dollars with little out of money pocket, by purchasing properties through financing.  This strategy may result in little to no cash flow, but eventually these investments will pay for themselves.

However, financing leverage can be a dangerous tool.  An over-leveraged investor could lose everything if lenders decide to call on the outstanding loans.

Cash on Cash Return Example

Earlier we looked at two properties for sale in Denver, CO.  We concluded an investor could reasonably make an offer of $903,846, based on CAP rates for similar properties, in the same market. 

To determine the Cash on Cash Return we need to understand how much financing this investor intends to utilize.  Let’s analyze two different scenarios. 

Scenario 1

This assumes a traditional purchase with bank financing requiring a down payment of 30%.

Scenario 2

This assumes a much more creative scenario.  In this scenario, we’ll assume the seller is willing to provide financing in the amount of $135,000, which is about 15% of the negotiated price.  Let’s also assume a local bank wants a down payment of 30% but agrees to utilize the seller’s 15% financing as part the down payment requirement.  In other words, the investor needs to come up with a down payment of only 15%. 

Comparing the Two Scenarios

In addition, let’s run these two scenarios with two different interest rate values, as shown below.

To recap, COC = (Net Operating Income – Debt Service) / Total Cash Invested

COC for the creative financing scenario at a 4% interest rate, the numbers look like this:

COC Return = ($48,938 – $30,731) / $135,577 = 13%

Back to the table. First, notice there is a big difference between the two financing methods.  Creative financing can yield a Cash on Cash Return as high as 13%!

Second, notice what a big difference a one percentage point in interest rates can make on the Cash on Cash Return.

Third, notice the difference in cash flow amounts.  The traditional financing scenario yields more cash flow, because it requires lower loan payments.

Again, an investor interested in growing their real estate portfolio may prefer the creative financing option, which results in higher COC returns.  Whereas an investor interested in cash flow may prefer the traditional financing option, which yields lower COC returns. 

Investment Opportunity – RV Park For Sale by Owner

If you have gone this far, you may be interested in an actual investment property for sale, I recently wrote about. This is an RV park for sale by owner, located in Arizona. I did a rough evaluation of this deal in the forum section of this website.

In full disclosure, I am not a broker, nor am I getting paid to advertise this. Simply, I enjoy enjoy searching for good investment opportunities. In addition, I am interested in creating an online community of likeminded investors.

CAP Rate Vs Cash on Cash Return Related Questions

Is CAP Rate the Same as Cash on Cash Return?

No, CAP rates measure income as a percentage of value.  Con Cash Return measures income (after debt service), as a percentage of total cash invested.  See CAP Rate Vs COC Return summary above. 

Is Lower or Higher CAP Rate Better?

A higher CAP Rate is better, unless the CAP rate is an outlier when compared to CAP Rates on similar properties.  In such cases a high CAP Rate can be indicative of a property that is not selling for a good reason.

How Much Cash Flow is Good for a Real Estate Rental Property?

Investor interested in growing their real estate portfolio prefer higher COC returns.  Whereas an investor interested in cash flow may prefer higher cash flow, rather than a higher COC Return. When growing a real estate portfolio, I like a 20% COC Return.

Conclusion

Let’s summarize this discussion on CAP Rate vs Cash on Cash Return. CAP Rate represents income as a percentage of asset price. Cash on Cash Return represents income (after debt service) as a percentage of cash out of pocket.

CAP Rates is used to compare similar properties. COC Return is used to understand cash flow, when financing is involved.

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Happy investing!

JC Keen