Capitalization rate (cap rate) and cash-on-cash return are both important metrics used in real estate investment analysis to evaluate the potential profitability of an investment property. However, they represent different aspects of the investment and are calculated differently.
Capitalization Rate (Cap Rate):
Definition: The cap rate is a measure of the potential return on investment (ROI) of a property based on its current market value or purchase price. It is expressed as a percentage.
Calculation: The formula for calculating the cap rate is:
Cap Rate = Net Operating Income (NOI) / Property Value or Purchase Price
– Net Operating Income (NOI) is the income generated by the property after deducting all operating expenses, but before accounting for financing costs (mortgage payments).
– Property Value or Purchase Price is the current market value of the property or the price at which you intend to purchase it.
Use: The cap rate is used to quickly assess the potential profitability of a property and compare it to other investment opportunities. Higher cap rates generally indicate higher potential returns, but they may also come with higher risks.
Limitations: Cap rates do not consider financing costs, taxes, or the time value of money. They provide a snapshot of the property’s income-producing ability at a specific point in time.
Definition: Cash-on-cash return is a measure of the actual return on investment (ROI) based on the cash invested in the property, taking into account financing costs (such as mortgage payments) and other expenses.
Calculation: The formula for calculating cash-on-cash return is:
Cash-on-Cash Return = (Net Operating Income – Financing Costs) / Cash Invested
– Net Operating Income (NOI) is the same as in the cap rate calculation.
– Financing Costs include mortgage payments, interest, and other costs associated with financing the property.
– Cash Invested represents the amount of your own money used for the investment, excluding borrowed funds.
Use: Cash-on-cash return provides a more detailed and personalized view of the investment’s profitability, as it considers the impact of financing. It helps investors understand how much cash flow they can expect to receive relative to the cash they’ve invested.
Limitations: Cash-on-cash return is sensitive to the financing terms, and it doesn’t account for property appreciation or depreciation, tax benefits, or changes in property value.
While both capitalization rate and cash-on-cash return are valuable metrics for real estate investors, they serve different purposes. Cap rate provides a quick way to assess a property’s potential, while cash-on-cash return offers a more nuanced view by considering the impact of financing on your returns. Investors often use both metrics in conjunction with other financial analyses to make informed decisions about real estate investments based on their specific goals and circumstances.
To experiment with Cap Rate & Cash on Cash Return cost calculations for real estate on Cape Cod, visit our STR Data Dashboard at www.CapeCodSTRData.com