“How did you end up?” You ask your real estate investor friend about a recent project. “All in at a 6.5 cap and a 14% cash on cash” They respond. “Great!” You respond while wondering what all that meant. There are a few ways to look at returns and ways to use these metrics to analyze your real estate deals.
Cash on Cash (COC)
For me, this is the most important return I consider when evaluating deals. Cash on cash is your actual cash return based on the dollars you invested. If you invested $100 into a project that produced an 8% COC, at the end of the year you would have $108. This return is calculated by taking your profit for a year and dividing it by your investment. In our example of having $108 at the end of the year, that is $8 in profits divided by a $100 investment which is 8%. $8 / $100 = 8%. This is one of the easiest returns to calculate because its only concern is cash flow. This return does not consider tax benefits, amortization, appreciation or depreciation. It does however consider the total monthly loan payments for the financing you plan to use. For example, if you use a 15-year loan instead of a 30-year loan, the higher mortgage payment lowers your cash return and your COC.
Return on Investment (ROI)
This is a far more common return used when looking at real estate, or any other investment. As the name suggests, it is your total return on your investment. Calculated by taking total profits for a year and dividing by your investment. It is much tougher to calculate because it accounts for everything in your deal that will impact profits. If you are looking at projected profits, you will be speculating because you must account for potential appreciation. This formula does not consider your loan principal payments, however. The interest on your loan is accounted for because that impacts profit, but the principal reduction is not included. For this reason and because of appreciation, it is possible to buy a profitable property with a negative cash flow. An example of what should be included in your profit formula is:
Start with the gross potential income and subtract the following to get the Net Operating Income (NOI)
- Vacancy factor (budget for vacancies)
- Interest expense (the interest portion of your loan payment)
- Taxes and insurance
- Operating expenses (maintenance, admin, management, etc.)
Then add back in the annual property appreciation and some investors will also add in the tax benefit of depreciation or amortization. These are sneaky tax advantages used to reduce income by reducing the value of your asset over time. The IRS requires that you do this on investment properties which is a big benefit to investing in real estate. I do not include these tax benefits when I look at a deal because they only reduce your tax basis meaning you will have a higher capital gain when you finally sell the asset.
Because you are including appreciation and not including principal paydown, your ROI should be higher than your COC.
Capitalization Rate (Cap)
This is mostly used in commercial real estate and is a great way to value an asset. The easiest way to think about a cap rate is what the property produces without any debt. If you were to pay cash for the property, what COC would you receive. To calculate this, you would take the NOI from the building and divide it by the price. Many investors use a cap rate to evaluate a property because you can quickly judge how the property is priced. Investors will then use a loan making both their COC and ROI higher than the cap rate. Taking the loan out of the equation helps to compare apples to apples.
Cap rates are so well known and used so frequently that it is the standard way to value commercial income producing real estate. To come up with a value of a property using cap rate you would take the total NOI and divide by the cap rate. For example, if you have $200,000 in NOI and can sell the building at an 8-cap, the value of that building is $2.5 million. $200,000 / 8% = $2,500,000. In a strong market like we are in now, the market might be at a 6-cap making the value $3.33 million. The lower the cap the higher the value.
All three returns are different and all three are important when analyzing your potential real estate deals.