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Cash-On-Cash vs. Cap Rate: Which Metric Investors Should Trust

Learn when to rely on cap rate vs. cash-on-cash return for smarter deal evaluation.

Austin Beverigde

Tennessee

, Goliath Teammate

Investing in real estate can be overwhelming, especially when trying to choose the right metrics to evaluate potential deals. Two commonly discussed metrics are Cash-on-Cash Return and Capitalization Rate (Cap Rate). Understanding the differences between these two can help you make informed investment decisions and maximize your returns.

Quick Answer: Cash-on-Cash Return measures the annual return on the actual cash invested in a property, making it ideal for assessing cash flow. Cap Rate, on the other hand, evaluates the property’s overall profitability based on its net operating income relative to its purchase price. Both metrics have their uses, but Cash-on-Cash is better for cash flow analysis, while Cap Rate is useful for comparing property values.

Understanding Cash-on-Cash Return

Cash-on-Cash Return is a straightforward metric that focuses on the cash income generated from an investment relative to the cash invested. This metric is particularly useful for investors who prioritize cash flow and want to understand their returns based on actual out-of-pocket expenses.

How to Calculate Cash-on-Cash Return

To calculate Cash-on-Cash Return, use the following formula:

For example, if you invest $100,000 in a property and generate an annual cash flow of $12,000, your Cash-on-Cash Return would be:

Understanding Capitalization Rate (Cap Rate)

Cap Rate is a metric that helps investors assess the profitability of an investment property based on its net operating income (NOI) relative to its purchase price. This metric is often used to compare different investment opportunities and evaluate the potential return on investment.

How to Calculate Cap Rate

To calculate Cap Rate, use the following formula:

For instance, if a property generates $30,000 in NOI and is valued at $500,000, the Cap Rate would be:

Cash-on-Cash vs. Cap Rate: Key Differences

While both Cash-on-Cash Return and Cap Rate are valuable metrics, they serve different purposes:

  • Focus: Cash-on-Cash focuses on cash flow, while Cap Rate assesses overall property value.

  • Investment Type: Cash-on-Cash is better for properties requiring significant cash investment; Cap Rate is useful for evaluating potential returns on properties regardless of financing.

  • Timeframe: Cash-on-Cash measures returns annually, while Cap Rate can be used for any period.

Realistic Examples

Before: Evaluating a Property with Cash-on-Cash

Imagine you purchase a rental property for $200,000, putting down $50,000 in cash. The property generates $24,000 in annual cash flow. Your Cash-on-Cash Return would be:

After: Evaluating a Property with Cap Rate

Now, consider the same property generates a Net Operating Income of $30,000. The Cap Rate would be:

In this case, while the Cash-on-Cash Return is high, the Cap Rate shows a solid overall property value.

Checklist for Investors

  • Determine your investment goals (cash flow vs. property value).

  • Calculate Cash-on-Cash Return for cash flow-focused properties.

  • Calculate Cap Rate for comparing multiple investment opportunities.

  • Consider both metrics for a comprehensive analysis.

  • Stay updated on market trends to understand property values.

Common Mistakes to Avoid

  • Relying solely on one metric: Using only Cash-on-Cash or Cap Rate can lead to incomplete evaluations.

  • Ignoring expenses: Failing to account for all operating expenses can skew both metrics.

  • Not considering financing: Cash-on-Cash is influenced by your financing method; understand how it affects your returns.

FAQs

What is a good Cash-on-Cash Return?

A good Cash-on-Cash Return typically ranges from 8% to 12%, but this can vary based on the market and individual investment goals.

How does leverage affect Cash-on-Cash Return?

Leverage can significantly impact Cash-on-Cash Return. Using borrowed funds to finance a property can increase your Cash-on-Cash Return if the property generates sufficient income.

Is a higher Cap Rate always better?

A higher Cap Rate can indicate a potentially better return, but it may also suggest higher risk or lower property quality. Always consider the context of the investment.

Can I use both metrics together?

Yes, using both Cash-on-Cash Return and Cap Rate together provides a more comprehensive view of an investment's potential, balancing cash flow and overall value.

What should I prioritize when investing?

Your investment priorities depend on your financial goals. If cash flow is crucial, focus on Cash-on-Cash Return; if you're looking for long-term value appreciation, consider Cap Rate.

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