Cap Rate vs. Cash-on-Cash Return: What CRE Investors Need to Know

Most investors turn to commercial real estate seeking to yield a substantial return on their investment. Measuring those returns, however, requires understanding the various financial metrics that can be used to evaluate a property's performance or potential performance. 

This article will discuss two common real estate metrics: the cap rate and the cash-on-cash return (CoC). Understanding the differences between these two metrics, how to calculate each, and when to apply them will help investors decide their risk management strategies and potential real estate investments. 

The Cap Rate

The capitalization rate or "cap rate" represents the net operating income (NOI) ratio to the commercial property's market value or purchase price. The cap rate is one way to convert a property's income into value by measuring its rate of return. Essentially, the cap rate answers a basic investment question: "For every dollar a property costs to acquire, how much can an investor expect to receive back each year in net rental income?"

The formula used to calculate the cap rate is: 

Cap Rate = Net Operating Income (NOI)/Property Value x 100

Net Operating Income (NOI) is the total income generated by a property minus operating expenses such as property taxes, maintenance and repairs, utilities, insurance, and management fees. NOI provides a picture of a commercial property's performance without factoring in finance costs. 

Property Value refers to either the purchase price or the current market value of the commercial property and represents the capital invested.

Cap Rate Example

As an example, let's say an investor has a property that generates $2,000 NOI per month, or $24,000 annually, and the property is valued at $300,000:  

$24,000 NOI / $300,000 = .08. or an 8% cap rate. 

The investor can expect an annual return of 8%.  

Note that the cap rate is a static metric that doesn't factor financing costs like a mortgage or debt service into its calculation or possible future expenses like capital improvements or vacancies. It also assumes a property's NOI is constant, which is not always true in a fluctuating market. 

Cash-on-Cash Return

Cash-on-cash return is a metric that calculates the ratio of net income generated by a commercial property relative to the initial cash invested in the property. Unlike the cap rate, which considers the property's overall value, cash-on-cash return focuses specifically on the amount of cash invested and tells an investor how much of their out-of-pocket investment is earned back each year.

The formula for cash-on-cash return is:

Cash-on-Cash Return = Net Cash Flow/Total Cash Invested

Net cash flow represents the amount of cash remaining after operating expenses (NOI) and debt service (mortgage payments) are deducted from the property's income.

Total cash invested includes the down payment, closing costs, and any additional capital expenditures required to acquire or improve the property.

Cash-on-Cash Return Example

For example, an investor makes a $60,000 down payment on a $500,000 commercial property that generates $48,000/year in rental income. The investor pays $12,000 in closing costs and has a monthly mortgage of $3,000, or $36,000 per year. To calculate the CoC return: 

$48,000 (rental income) - $36,000 (mortgage payments) = $12,000

$12,000/$72,000 (initial investment of $60,000 down payment + $12,000 closing costs) = 0.167

The cash-on-cash return is approximately 16.7%.

The annual cash-on-cash return percentage can fluctuate over time when other operating expenses are factored into the equation that affect the net cash flow year over year. These expenses can include property taxes, insurance, maintenance costs, vacancy rates, or capital improvements. Investors should monitor their cash-on-cash return at least annually to get an accurate picture of their cash flow.

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

Timing

The cap rate is helpful in the pre-buying stage as it provides insight into a property's potential by comparing its overall value to the income it generates. As a static metric, the cap rate is the same for all potential investors and allows agents and buyers a fairly simple way to identify and compare similar properties that fit a buyer's investment profile. 

Cash-on-cash return, on the other hand, is a tool often used after the purchase of a property to zero in on the cash flow generated relative to the cash invested, providing a more detailed view.

Financing

The cap rate doesn't take into account debt service or other financial arrangements, making it useful for apples-to-apples comparisons between properties regardless of their financing structure.

Cash-on-cash return accounts for mortgage debt and other leveraged costs when calculating cash flow, providing a more detailed and accurate picture of a property's performance.

Risk Assessment

Which Metric Should Investors Use? 

Both formulas are important tools for calculating potential returns. Deciding which metric to apply depends on what lens the investor wants to use to evaluate a property. 

The cap rate is a helpful way for buyers to screen similar properties in the same market that meet their investment criteria. For example, an investor who requires a cap rate of 5% or above can tailor their search accordingly. 

Because the cash-on-cash return factors leverage into the equation, investors can make decisions that affect the yield percentage before or after purchase. For example, they can choose to invest less capital to yield a higher return, or they may be able to make year-over-year adjustments to the property's operating costs in case the annual returns fall below a certain number. 

Knowledgeable real estate investors will use both metrics accordingly, along with several others, to evaluate opportunities, mitigate risks, and maximize returns.