Are you considering investing in a commercial property? Two key financial metrics to keep in mind are cap rate and cash on cash return. In this blog post, we’ll explain what these metrics mean and how to calculate them.
Cap Rate: What Is It and Why Is It Important?
Cap rate, short for capitalization rate, is a ratio that measures the potential return on investment of a property. Specifically, it’s the ratio of the property’s net operating income (NOI) to its current market value. The higher the cap rate, the higher the potential return on investment. However, a higher cap rate also implies a higher level of risk.
To calculate cap rate, divide the net operating income by the property’s current market value. For example, if a property generates $200,000 in net operating income and its market value is $4 million, the cap rate would be 5% ($200,000/$4,000,000).
Cash on Cash Return: What Is It and Why Is It Important?
Cash on cash return is another financial metric that measures the potential return on investment of a property. Specifically, it’s the ratio of the property’s annual pre-tax cash flow to the total cash investment. The higher the cash on cash return, the higher the potential return on investment.
To calculate cash on cash return, divide the annual pre-tax cash flow by the total cash investment. For example, if a property generates $150,000 in annual pre-tax cash flow and the total cash investment is $2 million, the cash on cash return would be 7.5% ($150,000/$2,000,000).
Differences Between Cap Rate and Cash on Cash Return
While both cap rate and cash on cash return are used to evaluate the potential return on investment of a property, they measure different aspects of the investment.
Cap rate measures the potential return on investment based on the current market value of the property, regardless of how the property is financed. Cash on cash return, on the other hand, measures the potential return on investment based on the actual cash invested in the property.
Additionally, the cap rate does not consider financing costs such as mortgage payments, while cash on cash return does. This means that cash on cash return provides a more accurate picture of the potential return on investment for the buyer, as it accounts for the actual amount of cash invested in the property.
Conclusion
When evaluating a commercial property investment, it’s important to consider both cap rate and cash-on-cash return, along with other factors such as location, condition, market trends, and future growth potential. While the cap rate measures the potential return on investment based on the property’s market value, cash on cash return measures the potential return on investment based on the actual cash invested in the property. You can make an informed investment decision by understanding these metrics and conducting thorough due diligence.
