These are two terms I’ve heard a lot recently, and think I have finally figured out the difference! Hopefully I can shed a little light on what they are and why they matter.
Cap Rate is the financial return on a property.
Cash on Cash Return is the financial return on your money.
In terms of properties, Cash on Cash Return is the Cap Rate with financing figured into it. If you buy a house all cash, the Cap Rate and Cash on Cash Return will be the same.
Ok, lets break it down a little further and use some numbers to clear things up.
Cap Rate is just short for the Capitalization Rate. It is used to pretty accurately find the annual financial return of a property.
To figure out the cap rate in real estate, you have to take into account all the expenses of a property and subtract it from the rental income to get a net income. Then it’s basically comparing that net income to the price of the property.
Something to note, the mortgage actually doesn’t get included in this formula. The Cap Rate will be fixed no matter what sort of financing you bring to the table. Cap Rate is here to tell you what the property is worth. How you fund it is unique to each owner. The financial performance of the house should be consistent across the board.
Confused yet? Let’s do an example.
You’re looking to buy a house for $100k total that rents for $1000 a month. Maybe not the best rental investment, but it’s something to work with.
Now figure out the monthly expenses on it (we’ll convert to yearly later). I’m good at making up numbers, so here’s a bunch of made up numbers:
- Insurance – $50
- Property Taxes – $50
- Repairs (10% is usually good) – $100
- Property Management (10% is normal) – $100
- Vacancy (I have a really good property manager who minimizes vacancies, so I’ll just go with 5%) – $50
Total expenses are $350. So your net monthly income is $1000 – $350, or $650.
Now to find the cap rate, it’s simply:
Net Yearly Income / Purchase Price
($650 * 12) / $100,000 = .078
So the Cap Rate is 7.8%
If you bought the house with cash, the return on your $100k would be 7.8%. Not too bad!
As a side note, what if you had gotten that $100k property for $80k instead? Your Cap Rate would bump up to 9.75% instead!
Cash on Cash Return
When you look at stocks or mutual funds, you typically look for the yearly percentage rate return, right? Cash on Cash Return does the same thing for you. Cash on Cash Return is the percent return on the money you put down towards an investment.
With rental properties, unlike traditional stocks mutual funds, you can use leverage – loans – to increase your returns while still only investing a relatively small portion of your own money.
Ok, let’s say you don’t have $100k cash, so you need to get a mortgage on it. Use all the same numbers above, but now we factor in the mortgage.
For a typical mortgage, you’re going to have to put 20% down, or $20k in this example. An $80k mortgage over 15 years at 4.5% comes out to $612.
We already established that the Net Income was $650, so now our net income is all the way down to $38. Ew! Now you could get a 30 year loan what would only cost $405 a month leaving your Net Income up to $245. But I don’t like long loans that long. But that’s completely up to you.
In any case, let’s run with the ugly $38 number. The formula to figure out cash on cash return is:
Net Yearly Income / Total Investment
We said you put down $20k, so your numbers come out to:
($38 * 12) / $20,000 = .0228
So the Cash on Cash Return is only 2.28%. Not great! If you had gone for a 30 year loan, it would have been a 14.7% return, which is much better!
But there is another way! Let’s say you got the house at a discounted price of $80k and used cash to buy the house. (Take a good read through that article to see how it’s done.) Usually when you go to the table with cash, you can get better deals that approaching it with financing. Using that method, you may not have to put down 20%, since you bought it with cash. So let’s say you only put down $10k, giving you a $70k mortgage.
Your mortgage payment is $536, giving a net operating income of $114. But also remember only $10k of your own money is in it.
So that comes out to:
($114 * 12) / $10,000 = 13.68%
That’s tons better! Just to keep numbers rolling, with a 30 year mortgage, that would come out to a whopping 35% cash on cash return!
Interpreting the Results
So what does this actually mean?
Take Example C using the 15 year loan. What we’re saying is that if you took $10,000, you’d be getting $114 *12 = $1368 back on it. Every year you get just over 13% of your money back again. Every year you make $1368 just for giving up your $10k. Great compared to the stock markets!
Where it gets really crazy, let’s say you manage to get a mortgage that’s essentially the same as your purchase price (zero down). (You can usually do that when you buy cash and then refinance. If you haven’t yet, take a look at the How Much Will My Bank Lend Me? post to see how that’s done.) Because these formulas don’t like dealing with zeros, let’s say you put $1 down. So your mortgage is $80k with a mortgage payment of $612 and Net Income of $38. Remember Example B, which gave us a 2.28% return? But when you get to put down $1 instead of $20k, that results in… get ready for it…
Yeah, you read that right. Essentially if you put down nothing ($0 instead of $1), the percentage goes to infinity. And no, your calculator’s not broken. What I’m saying is that you’d be earning $456 a year for putting absolutely zero of your own capital into it.
That’s what the Cash on Cash Return number is. If you put cash in, how much do you get out? Trying to get the most out for the least in is the fun part of the game 🙂
Oh, and if you want to truly break the system… get a mortgage higher than the purchase price. Got a $100,000 house for $70,000? Get a mortgage for $80,000. Your “down payment” is essentially a negative $10k, and yet you still have a positive Net Income. That gives a negative interest rate. Basically you’re getting paid to earn money. Hehehe.
Ok, enough goofing off 🙂 But this does get very exciting when you understand the Golden Egg of Real Estate! (That post will come out next week! Subscribe below to be sure you don’t miss it!)