Investing in real estate can be a lucrative investment when done right. How do investors measure their success though?
There are two main factors – cash on cash return and cap rate. Both formulas give you different information, helping you make informed decisions.
What Is Cash On Cash Return?
Cash on cash return is how quickly you earn the cash you invested back. In other words, the money you put down on the home – how long will it take to get it back from your returns on the investment property?
The cash on cash return formula is simple:
(Net operating income – Mortgage payment)/Cash investment = Cash on Cash Return
Let’s say you invested $60,000, have a $15,000 NOI, and annual mortgage payments of $8,000. Your cash on cash return would be:
(15,000 – $8,000)/$2=60,000 = 11.6% Cash on Cash Return
What’s A Good Cash On Cash Return?
Like most investments, there isn’t a ‘right or wrong’ return on your investment. It depends on your situation, risk tolerance, and expectations. Overall, most investors consider a cash on cash return between 8 – 10% good, but you have to determine what’s right for you.
What Is A Cap Rate?
The cap rate considers the property’s net operating income versus its market value. It’s a measure of your overall return on the property (or potential returns if you’re still deciding).
For example, if a property has a net operating income of $14,000 and the market value is $175,000, the cap rate is:
$14,000/$175,000 = 8%
You could expect an 8% return on your investment if you invested in the home.
Unlike the cash on cash return rate, the cap rate considers the net operating income, but not the mortgage payment (debt). This means it considers the operating costs, but not the debt costs.
If you compare cap rates, make sure it’s within the same market as each market has different average (targeted) cap rates because cap rates depend on the home’s age, location, the job market in the area, and demand for homes in that market.
Lastly, this article goes into more detail about how to calculate cap rate, and it includes several examples.
Using The Cap Rate To Compare Houses
Focusing on the cap rate can be a great way to measure your potential earnings, but be careful. Don’t automatically jump at a home with a much higher cap rate. First, find out why. Usually, it’s due to a low selling price, but why is it selling below market value?
A few common reasons include:
- A motivated seller who wants to sell fast
- The home has major issues and the seller is selling ‘as-is’
- The current seller didn’t price the rent high enough
While the cap rate is provided for you based on the asking price and current rent, don’t take it at face value. Dig further into the numbers. Is the rent fair for the area, or is it higher/lower? Is the asking price the norm for the area or is it higher/lower?
Just like you’d research a home to live in, do the same for a home you’ll invest in. You’ll be the landlord, the one responsible for all maintenance, repairs, and cash flow problems if you make a bad investment. Use the cap rate as a guide, but not your final determining factor.
Which Rate Is Better?
If you’re comparing offers the cap rate is a great metric because it doesn’t consider the mortgage payment – just the net operating income and market value. It’s easy to compare cap rates among homes in the same area to get an idea.
Again, don’t use it as your only metric though, as results can be skewed based on different factors.
If you’re looking for your individual rate of return, cash on cash returns provide a more personalized approach. It helps you make decisions not only on the house you’re buying but the financing you choose.
There Is No Right Or Wrong
There is no right or wrong answer, no matter how you look at it. Investing in real estate is a personal decision. Look at the numbers, know where you want to be, but most importantly, do your research on every property before deciding.