Cap rate vs. cash-on-cash return

Two of the most commonly used metrics are the Capitalization Rate (Cap Rate) and Cash-on-Cash Return (CoC Return). While both are used to evaluate investment performance, they serve different purposes and are calculated differently. In this article, we’ll dive into what each metric represents, how to calculate them, and when to use each for assessing real estate investments.

What is Cap Rate?

The Capitalization Rate, often referred to as Cap Rate, is a metric that helps investors evaluate the potential return on an investment property based on its income-generating ability. It’s expressed as a percentage and indicates the rate of return an investor can expect annually, assuming they purchase the property with cash and without financing.

Cap Rate Formula:

Cap Rate

=

Net Operating Income (NOI)

Property Purchase Price

×

100

Cap Rate=

Property Purchase Price

Net Operating Income (NOI)

​

×100

Where:

Net Operating Income (NOI) = Total Income - Operating Expenses (excluding mortgage payments).

Property Purchase Price = The total cost paid for acquiring the property.

Example:

Suppose a property generates $50,000 in annual net operating income and was purchased for $500,000.

Cap Rate

=

50

,

000

500

,

000

×

100

=

10

%

Cap Rate=

500,000

50,000

​

×100=10%

A 10% cap rate suggests a relatively high return, indicating potentially higher risk or a favorable purchase price.

When to Use Cap Rate:

Comparing Properties: Useful for comparing properties in the same market.

Risk Assessment: Higher cap rates often indicate higher risk and vice versa.

Market Insight: Helps assess if a property is overpriced or underpriced compared to similar assets.

Limitations of Cap Rate:

Ignores Financing: Cap rate does not consider mortgage payments or financing costs.

Static View: Reflects a snapshot based on current NOI, not future income growth potential.

What is Cash-on-Cash Return?

Cash-on-Cash Return (CoC Return) focuses on the actual cash yield an investor earns relative to the cash invested in the property. Unlike the cap rate, this metric takes into account financing by considering only the cash the investor has put down.

Cash-on-Cash Return Formula:

CoC Return

=

Annual Pre-Tax Cash Flow

Total Cash Invested

×

100

CoC Return=

Total Cash Invested

Annual Pre-Tax Cash Flow

​

×100

Where:

Annual Pre-Tax Cash Flow = NOI - Annual Debt Service (mortgage payments).

Total Cash Invested = Down payment, closing costs, and any upfront repair or renovation costs.

Example:

Let’s assume the same property generates $50,000 in NOI. With $20,000 in annual mortgage payments and $150,000 in total cash invested (down payment and other costs):

Annual Pre-Tax Cash Flow

=

50

,

000

−

20

,

000

=

30

,

000

Annual Pre-Tax Cash Flow=50,000−20,000=30,000

CoC Return

=

30

,

000

150

,

000

×

100

=

20

%

CoC Return=

150,000

30,000

​

×100=20%

This means the investor earns a 20% return on the actual cash they invested each year.

When to Use Cash-on-Cash Return:

Assessing Leveraged Investments: Ideal for evaluating properties with financing.

Cash Flow Focus: Helpful for investors who prioritize cash flow over property appreciation.

Comparing Leveraged Deals: Useful when comparing properties with different financing structures.

Limitations of CoC Return:

Ignores Appreciation: Does not consider property value growth over time.

Short-Term Focus: Only reflects current performance, not long-term returns.

Key Differences Between Cap Rate and Cash-on-Cash Return

Aspect Cap Rate Cash-on-Cash Return

Definition Measures return based on property income and purchase price. Measures return based on cash invested and cash flow.

Considers Financing? No Yes

Best For Comparing properties in the same market. Assessing leveraged investments and cash flow.

Formula Basis NOI and purchase price. Cash flow and cash invested.

Focus Property’s earning potential. Investor’s actual return on cash invested.

Limitations Ignores financing costs and appreciation. Ignores appreciation and long-term potential.

When to Use Cap Rate vs. Cash-on-Cash Return

Cap Rate:

Ideal for evaluating and comparing the earning potential of properties without considering financing. If you’re looking at two properties in the same market and want to know which generates a higher return relative to its price, cap rate is the way to go.

Cash-on-Cash Return:

Best for investors focused on cash flow and those using financing. It gives a clearer picture of how much return you get on your actual invested cash, making it useful for properties with different financing terms.

Example Comparison:

If Property A has an 8% cap rate and Property B has a 10% cap rate, B seems more attractive. However, if Property A has a 15% CoC return due to better financing and Property B has only 12%, Property A might be the better choice for an investor focused on cash flow.

Conclusion

Both Cap Rate and Cash-on-Cash Return are essential tools in a real estate investor’s toolkit, each serving different purposes. The cap rate is great for evaluating a property’s income potential regardless of financing, while cash-on-cash return is key for assessing actual returns based on the cash invested. Understanding when and how to use each metric can significantly enhance your investment decisions, ensuring you get the most out of your real estate ventures.