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Despite there being high demand for single-family homes to rent, simply purchasing a property doesn’t guarantee good returns. In fact, it’s important to reassess any properties you own regularly to ensure they are still good investments. In the case they no longer are, you can start planning an exit strategy as soon as possible and use your assessment to find better investment properties.
Figuring out a property’s potential means doing some rental accounting calculations. There are several main metrics you can use in this article we take a closer look at two of them: cash-on-cash return vs cap rate. Although both calculate return on investment (ROI) based on the financial health of your property, they have distinct purposes. It’s important to know which of them is right for your circumstances, how to use each metric and the significance of their formulas.
Cap rate (short for capitalization rate) shows you what profits you can expect to gain from your property as a percentage. It compares either annual returns or potential returns to the market value of your property. A higher percentage means greater projected profitability, but also a greater risk.
The cap rate formula is:
(Note: it’s important to use net operating income, not gross income.)
To put this formula into an example, let’s imagine an investor has a property with an NOI of $20,000 and a market value of $200,000. It would have a cap rate of 10 percent.
Just knowing the cap rate of a single property has little meaning — you need to put this value into perspective. A good cap rate as a buyer of an investment property tends to be between 8 and 10 percent with higher being better. To quickly compare many properties, you may like to input the formula into a spreadsheet to create a cap rate calculator.
You may notice some variation in cap rates between different markets. This tends to be due to a few main factors, including the appeal of the location, neighborhood amenities, demand for rental properties, and job opportunities in the area. The formula is excellent for revealing the impact these factors may have on profitability.
As a real estate investor, you may find cap rates useful for evaluating individual properties. However, you’ll still need to determine the reason for differences between properties that seem similar. For instance, the cap rate of one property could be high because the seller wants to offload the property soon. Alternatively, it could be because the property will require a large amount of work before it will be ready to rent.
You may also encounter markets with cap rates that are much lower than average. If properties are appreciating and will likely continue to do so, a cap return of just 3 to 4 percent could still be a good long-term investment.
Cash-on-cash return involves figuring out how much of your investment you’re likely to receive back. Like the cap rate, the value is a percentage. With this metric, a higher percentage means you can expect a faster return.
The cash-on-cash return formula is:
Imagine that the investor of the $200,000 rental property above makes a 25-percent down payment ($50,000). Remember that the NOI was $20,000. This would mean that the cash-on-cash return would be 40 percent.
It’s slightly more difficult to define a decent cash-on-cash return than a good cap rate — it often comes down to the investors’ discretion and the market the property is in. Investors may be satisfied with as low as 8 percent or they may want a return of at least 20 percent.
The above formula tells us the unleveraged cash-on-cash return in real estate, but you also need to consider the effects of leverage. By borrowing money, an investor can increase cash-on-cash return — provided the rate is less than the unleveraged return.
To understand the impact of leverage, let’s put our example of the $200,000 single-family home with an NOI of $20,000 into two scenarios.
In the first scenario, the investor takes out a loan at 6 percent interest (or $7,200 a year) at 70 percent loan-to-value — this equals $140,000, meaning equity required is $60,000. This puts the cash flow post debt service (NOI minus yearly interest) at $12,800. The cash-on-cash return therefore is:
Cash flow post debt service/equity required x 100
$12,800 / $60,000 = 21%
In the second scenario, the investor takes out a loan at 90 percent loan-to-value (which equals $180,000, meaning equity required is $20,000) and yearly interest is still 6 percent (which now equals $10,200). This puts the cash flow debt service at $9,800:
$9,800 / $20,000 x 100 = 49%
The second scenario will yield higher returns, but this investment also has a higher risk. The first scenario meets minimum requirements for most investors.
It’s difficult to say which is better: cap rate vs cash-on-cash return. It all depends on what you’re trying to learn about the investment properties you own or are considering purchasing.
Cap rate allows you to compare similar properties in a market by weighing annual income (or potential income) against market price. It tends to be quite clear if the cap rate of a property is desirable, although you do need to take into account how various factors are influencing the market. The right cash-on-cash return, in contrast, is much more dependent on the investor. Plus, leverage can have a big impact.
Although both cap rate and cash-on-cash return may seem simple, when you take other factors into account (such as calculating the effect of appreciation on cap rate or leverage on cash-on-cash returns), accounting does become challenging. In fact, whatever metric you prefer to use — cash-on-cash return vs cap rate — you’ll find it much easier to evaluate properties if you have rental accounting software.
Landlord Studio has you covered. We help you track your finances at every stage of the property investment journey, from before you purchase up until when you’re thinking about selling.
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Laura is a freelance writer and editor who specializes in advice for small business owners. She has written extensively on all kinds of real estate topics.
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