Cap Rate vs. Cash-on-Cash Return: Which Real Estate Metric Is Best?

Cap rate and cash-on-cash return are two of the most widely used real estate investing metrics, but which one should you focus on when analyzing an investment property? In this article, we’ll break down each term, show you how to calculate them (with examples), and tell you which one to use when looking at rental properties!

Summary:

• Cap rate and cash-on-cash return are common but different metrics used in investment property analysis.
• Cap rate measures a property’s potential profitability and level of "risk,” while cash-on-cash return measures your return relative to the cash you invested.
• You should calculate cap rate and cash-on-cash return whenever you’re analyzing a rental property, but you should revisit cash-on-cash return regularly.

Cap Rate Explained

Cap rate, or capitalization rate, forecasts a property’s expected annual return relative to its market value. It’s most often used to gauge the property’s long-term potential and the level of “risk” the investor is taking on.

How to Calculate Cap Rate

To calculate cap rate, you’ll first need to calculate the property’s annual net operating income (NOI). Subtract your annual expenses (not including any mortgage payments) from your annual gross rental income. You’ll also need to know the property’s current market value.

Once you have these numbers, simply plug them into Rent to Retirement’s cap rate calculator to determine your cap rate in seconds!

You can also calculate cap rate by hand using this formula:

Cap rate = annual NOI / market value

For example, let’s say you have a $300,000 property that brings in $2,000 each month after expenses ($24,000 annual NOI). Plug these figures into your cap rate calculator or the equation below:

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

What Is a Good Cap Rate?

5%-10% is widely considered a “good” cap rate, but this depends on the property type and location. You want your cap rate to be high enough that you’re making a reasonable return, but you don’t want it to be so high that it’s considered a “risky” investment. A higher cap rate could indicate that you’re buying a cheap or unstable property in a bad market.

Looking for stable rental properties with high potential profits?

Cash-on-Cash Return Explained

Cash-on-cash return measures a property’s rate of return relative to the amount of cash you originally invested in the deal. This is a crucial metric for investors, as you’re often putting 15%-25% or more down on an investment property. Cash-on-cash return gives you a clear picture of how much of that initial cash investment you’re earning back on an annual basis.

How to Calculate Cash-on-Cash Return

To calculate a property’s cash-on-cash return, you’ll first need to determine your annual pre-tax cash flow by subtracting all operating expenses and debt service (mortgage payments) from your gross rental income. Enter this number and your initial cash investment into Rent to Retirement’s cash-on-cash return calculator, which does all of the work for you!

Alternatively, you can plug your figures into the formula below:

Cash-on-cash return = annual before-tax cash flow / total cash invested

Using the same example as above, let’s say you put 20% down ($60,000) on your $300,000 property and have a monthly mortgage payment of $1,500. After your expenses and mortgage, you’re left with $500 in monthly cash flow ($6,000 annually). Now, enter these numbers into your cash-on-cash formula:

$6,000 / $60,000 = .1 or a 10% cash-on-cash return!

But let’s say you were using Rent to Retirement’s 5% down new build investment loan. You’d have a higher mortgage payment, around $1,800, but would only need to put $15,000 down. With $200 in monthly cash flow ($2,400 annually), your cash-on-cash return would look like this:

$2,400 / $15,000 = .16 or a 16% cash-on-cash return! 

Get a higher cash-on-cash return with Rent to Retirement’s 5% down new build loans!

What Is a Good Cash-on-Cash Return?

8%-12% is considered a “good” cash-on-cash return, but it depends on the property’s location, your investing goals, and current market conditions. A higher cash-on-cash return usually means you’re getting more bang for your buck!

Browse turnkey rental properties with high cash-on-cash returns!

Key Differences Between Cap Rate and Cash-on-Cash

Cap rate and cash-on-cash are very different metrics, so you should know what they are and when to use them. Here are some of the main differences between the two:

1. Purpose

Cap rate is used to measure potential performance and is a great screening metric when analyzing a rental property, especially in commercial real estate. Cash-on-cash return is used to measure your annual return on investment, often on a property you already own.

2. Leverage (Debt)

Cap rate is an “unlevered” metric, meaning it doesn’t account for debt service. You’re simply taking the property’s projected income and dividing that figure by its total value. Cash-on-cash, on the other hand, is a “levered” metric, meaning you must factor your mortgage payment into your annual before-tax cash flow.

3. Property Value

Cap rate measures annual returns against the property’s current market value. Cash-on-cash return doesn’t take property value into account; it only measures your return against the amount of cash you initially invested in the deal.

4. Timing

You typically calculate cap rate before buying or selling an investment property, as it can tell you how “risky” the property might be. You can calculate cash-on-cash return before you buy, but you should recalculate this number annually to ensure you still have a good investment on your hands!

Sport a higher cash-on-cash return with 5% down new build turnkey rentals! 

Which Matters More? (Cash-on-Cash Return vs. Cap Rate)

Neither metric is “better” than the other. Both are useful and can provide you with different information:

When to Use Cap Rate

Investors calculate cap rate when looking to buy or sell, and it’s more commonly used in commercial real estate. Because the cap rate is the same for all investors, you can compare the cap rates of similar properties and use this information to back into a fair purchase price.

When to Use Cash-on-Cash

You can calculate cash-on-cash return before you buy, but you should also recalculate this number annually. As your expenses (and potentially even your mortgage payment if you refinance) change, you could think differently about the investment.

When to Use BOTH

Smart investors look at both metrics (and others) whenever they analyze a rental property. Cap rate will help you measure the risk you’re taking on, while cash-on-cash will tell you whether your hard-earned money is working hard for you!

Buy High Cash-on-Cash Rental Properties!

If you’re looking for rental properties with rock-solid cap rates and high cash-on-cash returns, consider turnkey rentals!

These newly built or renovated properties are often less risky than other investments, especially for new or inexperienced investors. For one, they require less maintenance than the average property, allowing you to keep your operating expenses down. What’s more, Rent to Retirement has 5%-down financing and discounts on new builds, which means less cash invested and (potentially) a higher cash-on-cash return!

Cap Rate vs Cash-on-Cash Return FAQs

Is Cash-on-Cash Return the Same as Cap Rate?

No, cash-on-cash return and cap rate are two different metrics. Cash-on-cash return measures rental income against your original investment, while cap rate measures a property’s risk and potential profitability.

Is Cap Rate the Same as Cash Flow?

No, cap rate and cash flow are not the same. Cap rate is the relationship between net operating income and property value, while cash flow is the amount of profit left over after all expenses and debt service (mortgage) are paid.

What Does 7.5% Cap Rate Mean?

A 7.5% cap rate means your annual net operating income equals 7.5% of the property’s value. Although it depends on the property and your market, a 7.5% cap rate generally indicates that you’re getting a reasonable annual return and taking on a moderate level of risk.