Real estate investors frequently use three metrics to measure the performance of an income-producing property: capitalization (cap) rate, return on investment (ROI) and cash-on-cash returns. It’s recommended to use all three to get the best understanding of a property’s potential rate of return. The ROI formula is annual return divided by total investment.
If you found a rental property that you’re interested in purchasing, contact Visio Lending. It’s a reputable, online, nationwide lender that offers competitive rates to prime borrowers. You can get prequalified in just a few minutes.
When to Use Real Estate Investment Formulas
Typically, the more information you have about a property, the more informed a decision you make in regard to purchasing it or keeping it in your portfolio. For that reason, using all three formulas is recommended. However, there are situations when you may be short on time or just want a quick formula to analyze a property’s rate of return so just want to use one formula.
Cap rate measures the rate of return on a property. You can calculate a property’s cap rate by using the cap rate formula, which is net operating income divided by current property value. Cap rate is typically used as a way to compare two similar properties in the same property class — for example, two commercial buildings.
Generally, buy-and-hold investors will look at that cap rate to see how well the property is performing during a one-year period. However, cap rate can’t be used on fix-and-flip properties because there’s no rental income. Keep in mind that cap rate also doesn’t take into account mortgage payments.
Return on Investment
ROI is used to determine how well your piece of real estate is performing. It’s generally considered your annual return divided by your total investment. Typically, the lower your cost, the higher your ROI. You can use ROI on both fix-and-flip and buy-and-hold investments and the ROI formula allows for your mortgage to be considered, which isn’t the case with the cap rate formula.
Cash-on-cash return is a real estate metric that analyzes the performance of your asset. It also takes into consideration the debt on a property, such as your mortgage, similar to ROI but different from using a cap rate. The cash-on-cash return formula can vary but is generally your net operating income divided by your total cash investment, and it includes things like your lender fees and closing costs.
Cap Rate vs. ROI vs. Cash-on-Cash Returns
Whether to use cap rate vs. ROI or cash-on-cash returns is something that real estate investors have to decide when evaluating properties. Typically cap rate is used on multifamily properties, commercial buildings and apartment buildings. It’s not used on fix-and-flip properties because net operating income (NOI) is used in the cap rate formula and there isn’t any NOI for a fix-and-flip project because there’s no rental income.
Investors typically use cap rate to compare properties, in addition to also using cash-on-cash returns, comparable property sales prices and ROI. Conversely, investors use ROI to analyze both long-term investment properties as well as fix-and-flip properties. The ROI is the overall rate of return on a property including debt and cash invested. ROI does take the debt on the property into consideration.
Both commercial and residential investors typically use cash-on-cash returns to evaluate the cash flow coming in from income producing properties. However, it typically isn’t used by fix-and-flip investors since they don’t have any monthly rental income. Cash-on-cash returns typically provide a more accurate analysis of the investment property’s performance when compared to the property’s ROI. This is because cash-on-cash returns only measure the return on the actual cash invested and doesn’t include the debt.
How to Calculate Cap Rate on an Investment Property
Investors can calculate cap rate by hand or by using a cap rate calculator. To calculate cap rate by hand, you simply divide the property’s NOI by the current property value and multiplying it by 100 to get a percentage. The cap rate typically measures the property’s rate of return over a one-year period. Unlike ROI, it’s only used on income-producing properties and usually properties with more than one unit.
When you’re calculating the cap rate, keep in mind that it’s calculated based on annual returns. This means if a property performed well or poorly for one year, this will show up in the cap rate calculation. It also means that an investor isn’t getting a full overview of the property for the past several years.
For example, if the property had a few prior years of poor performance the cap rate may be deceiving in that is only shows one positive year of returns. That’s why it’s important to use more than one metric when evaluating an investment property.
For a more in-depth look, including what a good cap rate is, read our capitalization rate article.
Cap Rate Formula
Cap Rate Formula = NOI / Property Value x 100
For the first part of the cap rate formula, we need to find out what the NOI is. This is the amount of cash flow generated by an investment property after subtracting operating expenses, but before principal and interest payments, capital expenditures, depreciation and amortization.
Next, you find out the property value, by having a real estate agent conduct a comparative market analysis or getting the property appraised. You can also get a rough estimate of what your property is currently worth on sites like Zillow. Then, you multiply that number by 100 to figure out the cap rate. A good cap rate is typically 4 to 7 percent or higher, although it does depend on property class and location.
Cap Rate Example
Now that we know what the cap rate formula is, let’s look at an example. Let’s assume that we want to figure out the cap rate on an apartment building in an area that has average cap rates of 7 percent.
Let’s assume the NOI of the apartment building is $80,000, and the apartment building is worth $1.2 million.
First, we divide the NOI by the property value.
$80,000 / $1,200,000 = 0.067
Then, we multiply by 100 to get a 6.7% cap rate.
Now, we can use that cap rate to compare it to the average for apartment buildings in the area and decide that the NOI is low for that building, or we may want to offer a lower purchase price so that the cap rate will be more in line with the 8 percent average in the area.
How to Calculate ROI on an Investment Property
An alternative or addition to calculating cash-on-cash returns and cap rate, is calculating your ROI. Concerning real estate, ROI is your return on your total investment in the property. It includes both the cash you invested and any debt that you leveraged on the property including things like an investment property loan.
ROI differs from cap rate because it considers your mortgage payment in the formula. It also differs from cash-on-cash returns because it takes into consideration, not just the cash you spent for the downpayment and lender fees but also the amount of money you financed.
ROI can be skewed because it appears as if your return on investment is greater when you have a mortgage than if you paid using all cash. This is why it’s so important to use more than one way of analyzing an investment property before you purchase it.
ROI = Annual Return / Total Investment x 100
Generally, investors calculate their annual return by subtracting their property related expenses from their total rental income to get their NOI. Then, you divide this by your total investment, which is how much you have in the property including cash and debt. Finally, you multiply that number by 100. Typically, a good ROI is anything above 10 percent on an investment property and more than 15 percent on a fix-and-flip.
If you want to calculate your ROI on a rental property easily, use our free rental property calculator.
Let’s take a look at an example of an investor using the ROI formula to decide if they want to purchase a duplex.
Let’s assume that the annual return of the duplex is $24,000, and the total investment needed to purchase the duplex is $150,000.
First, we divide the annual return by the total investment, and then multiply by 100 to get a percentage.
$24,000 / $150,000 x 100 = 16% ROI
The 16 percent figure is considered to be a high ROI on an income producing property. Once you know the ROI, you can compare it to other ROIs on similar properties in the area, and you can compare it to other investment options to see which will yield you the highest return.
How to Calculate Cash-on-Cash Returns on an Investment Property
Cash-on-cash returns measure the return on the actual cash invested into the investment property. It’s also referred to as the cash yield on an investment property. Investors who pay all cash for a property often use cash-on-cash return as a quick tool to see their rate of return.
Cash-on-cash returns can help investors prescreen a property. It’s also an easy way to compare properties based on a relatively simple calculation. This is in comparison to ROI, which is more complex and takes more time and more knowledge about the property.
Besides measuring the current return, the cash-on-cash return can also be used to forecast future cash distributions of an investment property. Keep in mind that it’s not a guaranteed future return but, instead, investors use it as a targeted future return and as an estimate of what the property will produce in the future.
Cash-on-Cash Returns Formula
Cash-on-Cash Return = Annual Pretax Cash Flow / Actual Cash Invested x 100
The cash-on-cash return formula is generally considered to be one of the most used and simple real estate investing formulas. Cash-on-cash return equals the annual pretax cash flow divided by the actual cash invested multiplied by 100.
To figure out your annual pretax cash flow, you add your gross scheduled rent plus any additional property derived income minus your vacancy minus operating expenses. Now, for the next part of the equation, you need to know how to calculate your actual cash invested. You do this by adding together any cash you invested in the property including your down payment, closing costs and property repairs.
Cash-on-cash returns can be used in addition to cap rate and ROI to find out how well a rental property is performing, if it’s a good value and how the subject property compares to other properties. Typically, 8 to 12 percent is considered a good cash-on-cash return. Keep in mind, that this number is skewed if you finance the property, and you need to make sure you can afford the monthly mortgage payments.
Cash-on-Cash Returns Example
Let’s look at an example of an investor using cash-on-cash return to decide if she wants to purchase a duplex. Let’s assume that you know that your actual cash invested is $75,000 which is your down payment, closing costs and rehab costs. Now, let’s assume that your annual pretax cash flow is $12,000.
You divide your annual cash flow by your total cash invested and then multiply by 100.
$12,000 / $75,000 x 100 = 16% cash-on-cash return
This is considered a high cash-on-cash return, so it would most likely be a good property to invest in. However, you should factor in your financing costs if you finance the property and look at the cap rate and ROI as well.
Pro Tips on Using Cap Rate vs. ROI vs. Cash-on-Cash Returns Formula
Cap rate vs. ROI and the cash-on-cash returns formula can get a little bit confusing when analyzing real estate. Remember, that we recommend using all three metrics as much as possible when figuring out the rate of return and performance of an income producing property.
Here, we have a few thoughts from the pros on cash-on-cash returns and cap rate vs. ROI.
1. Use Cap Rates to Compare Similar Properties
When investors use cap rates to analyze income-producing properties, they need to compare apples to apples. This means that they need to compare properties cap rates by the location they’re in, as well as the property class. For example, a duplex in the countryside shouldn’t be compared to an office building in a metropolitan area.
“Cap rates are useful for investors to compare between projects; however, it’s not always black and white. For example, an investor may have a lower cap rate in a top market and a higher cap rate in a submarket. Therefore, while one can compare the cap rates for each project, other factors must be taken into consideration before making a decision.”
— Puja Talati, Partner, Enzo Multifamily
2. Use the Same Calculations to Compare Real Estate Investments
It doesn’t do you much good if you use different calculations on different properties and then compare them, expecting the results to help you make a purchase decision. It’s recommended to use the cap rate, ROI and cash-on-cash returns for each property. However, if you only use one, make sure it’s the same one for each property you analyze and compare.
“I think the most important thing to realize is just to make sure you’re using the same calculation when comparing investments. So, for example, don’t look at the ROI on one investment and compare that to the cash-on-cash return of another investment. Make sure you are either comparing the ROI of both of them or the cash-on-cash return of both of them.”
— Cornelius Charles, Co-owner, Dream Home Property Solutions, LLC
3. Use a Combination of Investment Formulas to Compare Properties
Cap rate, ROI and cash-on-cash returns can each stand on their own when analyzing and comparing investment properties. However, the most accurate results come from using all three formulas.
“Cap rate and cash-on-cash returns are both important metrics to consider when evaluating real estate investments. Both of these numbers are ways to determine the ROI of a real estate investment. Specific to multifamily, I suggest using a combination to evaluate any deal.”
— Veena Jetti, Founding Partner, Enzo Multifamily
Cap Rate vs. ROI Frequently Asked Questions (FAQs)
Below, we’re going to address some of the most frequently asked questions on cap rate vs. ROI, how to calculate ROI and the cash-on-cash return formula. If you have an additional question or would like to submit a comment, please visit our forum.
What Is a Good Cap Rate?
A good cap rate depends on the property type, location and net operating income. Generally, investors want a cap rate above 4 percent on residential real estate and more than 7 percent on commercial real estate. A higher cap rate is generally preferred because it means the property’s fair market value is relatively low compared to the NOI.
What Is the Cash-on-Cash Return Formula?
Most real estate investors use the following cash-on-cash return formula: Net operating income divided by your total cash investment. As we mentioned above, your net operating income is your potential rental income plus other income minus vacancy losses -minus total operating expenses.
How to Calculate ROI on a Fix-and-Flip Project?
The ROI formula is simply your annual return divided by your total cash investment. However, calculating the ROI for a fix-and-flip is difficult because you have to work backward to get the variables. These include the property’s acquisition, rehab and sales and marketing costs. To make this easier, check out our free house flipping calculator.
What Is a Cap Rate Calculator?
A cap rate calculator is a tool that helps investors determine the rate of return on their real estate investment. It includes inputs like property value, gross annual rental income, operating expenses and vacancy rate. After the investor fills in the inputs, the cap rate calculator will give an output of your capitalization rate.
The Bottom Line
Real estate investors use different formulas to analyze how income-producing properties are performing and to make decisions on whether they should buy or lease commercial real estate. Investors often debate if they should use cap rate vs. ROI in their analyses. However, it’s typically best to use cap rate, ROI and cash-on-cash returns to get a comprehensive financial picture of the property.
When you’re ready to purchase a rental property, contact Visio Lending. They’re a reputable, online, nationwide lender that offers competitive rates to prime borrowers. You can get prequalified in just a few minutes.