Cap Rate vs Cash on Cash Returns: How to Measure Your Real Estate Investment ROI

The goal of investing in a real estate property is to make a financial return on your money investment. In order to make a smart investment, it is important to understand how the industry measures their return on invesments (ROI).

There are two main metrics for measuring ROI – Cap Rate and Cash on Cash Return. Both are commonly used to compare one real estate investment to another, and provides insights into the performance of a particular investment. So what’s the difference? Let’s dive into it.

What is a Cap Rate and How To Use It?

The Captilization Rate ( or simply Cap Rate) in the real estate industry describes the the net operating income relative to the value of your real estate property. Specifically, the Cap Rate is a % rate of the computed net operating income expected from the property, divided by the property asset value.

Below is the formula needed for the calculation:

Capitalization Rate = Net Operating Income / Current Market Value

Net Operating Income is the annual income the property generates; which would be rental income if you are renting the space out for money. The “Net” part of the term means that you must also subtract from the income any expenses accrued during the year for the property. Expenses may include costs paid towards repairs, mortgage, insurance, and property tax.

Current Market Value is the value of the present-day value of the property in the market. In other words, how much is the property worth today if you were to sell it. If you’re looking to invest in new properties, this number may be the same as the cost of the property. One thing to note is that if you want to calculate the Cap Rate of property you already own and compare it to new investment, you should use its current market value, and not the cost you bought it at. Using the current market value ensures that the Cap Rate % is up-to-date, and comparable with current potential investments. If you were to use the actual cost of the original purchase, then the Cap Rate % would only be meaningful in comparison with other properties at that time.

Example Cap Rate Calculation

Let’s start with the following assumotion with your rental property:

• You buy a rental property at its current market rate for $1 million.
• Assume that the total rent received per year will be $100,000 or $8334/month.
• Assume that the total expenses accrued for the year would be $20,000.
• You paid all $1 million for the property.

If you had absolutely no expenses, then the Cap Rate would be $100,000 / $1 million = 10%.

However, you will always have expenses associated with your rental property. Assume that the total expenses accrued for the year would be $20,000. This expense includes costs for :

• Renovations costs
• Property tax
• Utility
• Unexpected vacancies

If you include expenses, the Cap Rate would then be ($100,000 – $20,000) / $1 million = 7%.

Note that the Cap Rate can change based on any adjustment to these numbers. Cap Rate will go up if Rental Income goes up, Cap Rate will go down if Expenses go up. Cap Rate can be incredibly useful to measure your performance in the past, as well as a great way to project how well the investment will perform in the future.

What is Cash on Cash Return and How to Use it?

The cash-on-cash return is a rate of return to calculate the cash income generated by the property compared to the cash invested in a property. Specifically, the cash-on-cash return measures the annual return you are making from the property relative to the amount of mortgage paid during the same year.

The formula for cash-on-cash return rate is:

Cash on Cash Return = Annual Pre-Tax Cash Flow / Total Cash Invested

The Annual Pre-Tax Cash Flow can be calculated by: (Gross rent + Other income) – (Vacancy + Operating Expenses + Annual Mortgage Payments)

Total Cash Invested is the total amount of cash you personally have put into the investment. Note that this is different than the property cost as you might have used to calculate the Cap Rate.

This metric is particularly important because most investors are not paying the full cost on the property themselves. Rather they would be borrowing money from banks through a mortgage loan.

Example Cash-on-Cash Return Calculation

Let’s start with the following assumptions with your rental property:

• You buy a rental property at its current market rate for $1 million.
• Assume that the total rent received per year will be $100,000 or $8334/month.
• Assume that the total expenses accrued for the year would be $20,000.
• You invested only $250,000 in to the property.
• You take a $750,000 mortgage, with 30-month fixed 4% rates.
• Mortgage payment is $3,581 a month or $42,972 a year.

To calculate the annual pre-tax cash flow, you want to calculate how much net cash is being earned before taxes. In this case the annualized cash flow would be $100,000 of rent – $20,000 operating expenses – $42,972 mortgage = $37,028 in annual income.

Since you only put down $250,000 in cash, then the Cash-on-Cash Return is $37,028/ $250,000 = 18.5%.

For every $100,000 you put into such an investment, you can make $18,500 back per year!

What if you did not take out a mortgage and paid the full cost of the property? If that’s the case, then your total cash invested would be $1 million; the annualized cash flow would be $100,000 of rent – $20,000 operating expenses = $80,000; and the cash on cash return would be $80,000/$1 million = 8%.

As you can see, if you did not take a loan, for every $100,000 you put into such an investment, you only get $8000 back. This is significantly less than the cash-on-cash return in the scenario where you took out a mortgage. This situation illustrates how you can leverage your investments by borrowing debt from banks.

Calculate Cash-on-Cash Return to Decide if You Should Leverage a Mortgage in your Real Estate Investment

A critical difference between a leveraged investment and one that is not is that you borrowed money from the bank; and you must return that money via monthly mortgage payments. Let’s take a look at the risk of leveraging a mortgage for a real estate investment.

Let’s take the situation where your leveraged rental property investment shuts down and fails to make money from rent (for example during Covid-19 pandemic), so you cut expenses in half. Then the annualized cash flow could be $0 rent – $10,000 operating expenses = -$10,000 – $42,972 mortgage = -$52,972 . The cash-on-cash return would be -$52,972/$250,000 = -21.2%.

In the same situation, compared to your rental property investment you paid in full, the annualized cash flow would be $0 rent – $10,000 operating expenses = -$10,000. The cash-on-cash return would be -$10,000/ $1 million = -1%.

From the calculating the cash-on-cash return with these 2 situations, you could see that it is significantly less risky if you stay away from mortgage loans in case something goes wrong. This risk for when things go wrong is the same reason why the ROI from leveraging a mortgage can be so great when things go right. This is not investment advice, but by calculating the cash-on-cash return % for different scenarios, you can temper your expectations of how well your investment can do.

Bottom Line

Both Cap Rate and Cash-on-Cash Return are very important metrics to use when calculating ROI. The real estate industries use these two metrics when understanding and comparing the value for various investment properties. These two metrics calculate different things, and can provide different type of insights to your real estate rental investment.

Cap rate is used to compare relative overall value of similar real estate investments. On the other hand, cash-on-cash return is used to measure cash return for the current period. Because cash-on-cash return is based on cashflow, it is much more useful to forecast projected earnings and expenses for the year.