Cap rate (or capitalization rate) and cash on cash return (CoC) are certainly two of the more popular and commonly used measures real estate investors look for to determine rental property profitability.
Most real estate evaluations contain them, and in fact it would be rare for a real estate analysis not to include them, nor for real estate investors not to consider them.
In this article, we will provide a brief overview of both returns for those of you new to real estate investing in order to give you an idea of what they are and how they apply to the investment process.
Capitalization rate is a return that measures the ratio between a property’s net operating income and its sale price (or value).
Cap rates are mostly used to determine whether or not a property’s value is in-line with other similar rental properties in the general market area.
For example, if an apartment building is listed at $600,000 and generates a net operating income of $47,880 we can safely assume that the property is listed at a 7.98% cap rate merely by dividing the net operating income by the sale value.
Net Operating Income / Sale Price = Capitalization Rate
$47,880 / 600,000 = 7.98%
Okay, now we can determine whether it is listed at a fair market value by comparing it to the capitalization rates other similar rental properties recently sold for in the area.
Step one. Divide each sold property’s net operating income by its sale price and then compute an average for those cap rates.
Step two. Compare that average to that for the subject property.
For instance. In our example we concluded that our subject rental property has a capitalization rate of 7.98%. If the average capitalization rate in our local market is higher than that, we can conclude that our property appears to be priced higher than fair market value, and perhaps over-priced; and if lower, that our property is priced in line with market values, and perhaps under-priced.
Cash on Cash Return
The cash-on-cash return (or COC as it’s labeled in many real estate analysis reports) measures the ratio between the annual cash flow generated by the property and the cash required to make the investment.
Cash-on-cash mostly is used for the investor to determine the return that will be earned on the initial investment he or she is required to make for the purchase. So this is about the investor’s cash outlay and the property’s cash flow, and is irrespective of value.
For example, if a buyer must invest $94,400 cash to purchase an apartment building generating an annual cash flow of $11,934, CoC will tell the investor that he or she will earn a rate of return of 12.64% on the initial cash investment for that year.
Cash Flow / Initial Cash Investment = Cash on Cash Return
$11,934 / 94,400 = 12.64%
Rule of Thumb
Naturally, real estate investors would not rely upon any single return to tell the whole story about an income property’s financial performance. Nor would they look to any single return alone to make a real estate investment decision.
Nonetheless, both capitalization rate and cash on cash rate of return do provide investors with an upfront idea about the property, and in turn suggest whether or not it’s worth pursuing as a real estate investment.