Cap Rate vs. Cash-on-Cash vs. ROI: The Ultimate Guide to Real Estate Investment Metrics
This comprehensive guide will provide clarity around the Cap Rate, Cash-on-Cash, and ROI investment metrics by diving into the similarities, differences, and applicable use cases. Following that, we will use the BusinessCaseGuy.com real estate investment calculator to easily analyze a real scenario in minutes.
Introduction
Investing in real estate is a significant investment decision that requires a lot of capital and carries its share of pros, cons and risks (refer to the article here). When it comes to metrics, the most used industry metrics are the Capitalization (Cap) Rate, Cash-on-Cash, and Return on Investment to analyze investment benefits. But which one is the best? When should you use it? Is there a single answer? Spoiler alert – there isn’t one correct answer, but each metric has its advantages and disadvantages, which we’ll explore in depth.
Whether you’re a novice seeking to grasp these concepts or an experienced investor looking for a refresher, this guide and real-estate returns calculator will equip you with the knowledge needed to make informed investment decisions.
Table of Contents
Definition of Cap Rate, Cash-on-Cash, and Return On Investment
Let’s first define the terms and formulas, then work through some simple examples. Once this is understood, we’ll dive into a comprehensive review and comparison of each using a real property example to show how to evaluate the performance of an investment property.
Each definition will use the below figures as part of their examples.
- Purchase Price or Market Value: $500k
- Down Payment or Equity Invested: $80k
- Up-front Expenses: $20k
- Revenue: $40k / year
- Operating Expenses: $16k / year
- Annual Mortgage Payment: $20k ($11k of Principle + $9k of Interest)
- Appreciation: 2%; as a dollar amount = $500k * 2% = $10k year
Capitalization Rate (Cap Rate)
The Cap Rate evaluates a real estate investment’s profitability and return potential during the first year, excluding any start-up expenses or costs associated with mortgages or loans. To do this, the Cap Rate takes the property’s net operating income and compares it to the current market value. Here is the formula for the Capitalization Rate.
Using the sample numbers above, the calculation is as follows (expressed as a %)
- Cap Rate = (Net Operating Income) / (Market Value)
- Cap Rate = (Annual Revenue – Annual Operating Expenses) / (Market Value)
- Cap Rate = ($40k – $16k) / ($500k)
- Cap Rate = ($24k) / ($500k)
- Cap Rate = 4.8%
Cash-on-Cash Return (CoC)
The Cash-on-Cash Return gives investors a view of the property’s performance by considering only cash invested upfront versus the net cash flow in the first year of operations. Here is the formula for the Cash-on-Cash Return.
Using the sample numbers above, the calculation is as follows (expressed as a %)
- Cash-on-Cash = (Net Cash Flow) / (Total Cash Invested)
- Cash-on-Cash = (Revenue – Operating Expenses – Mortgage Payment) / (Down Payment + Start-up Expenses)
- Cash-on-Cash = ($40k – $16k – $20k) / ($80k + $20k)
- Cash-on-Cash = ($4k) / ($100)
- Cash-on-Cash = 4%
Return on Investment (ROI)
Return on Investment (ROI) is a broad and deep metric that considers the total gain or loss from an investment over a period of time, based on the equity invested. ROI considers the downpayment, all upfront costs, net operating income, mortgage and debt costs, and non-cash benefits such as market value appreciation.
ROI is a standard investment metric used outside of real estate. Simply put, ROI is your Equity Growth / Equity Invested. However, we need to get very specific for real estate to know which figures to use.
There are varying opinions on which figures to use. Based on my research, I’ve pulled as many factors as possible into the equation. Here are the essential groupings within the formula.
Using the sample numbers above, the calculation is as follows (expressed as a %)
- ROI = Equity Growth / Equity Invested
- ROI = [ (Start-up Expenses) + (Operating Cash Flow) – (Mortgage Interest) + (Mortgage Principal) + (Price Appreciation) ] / (Equity Invested)
- ROI = [ (-$20k) + ($40k – $16k) – ($9k) + ($11k) + ($10k)] / ($80k)
- ROI = [ $16k ] / ($80k)
- ROI = 20%
These definitions and examples are essential as we move forward through the article. Please refer back to them as needed. With that said, let’s move into the side-by-side comparison of these metrics in the next section.
Side-by-Side Comparison of Cap Rate, Cash-on-Cash, and Return On Investment
Now that we’ve established the definitions and worked through some simple examples of Cap Rate, Cash-on-Cash Return, and Return on Investment, let’s compare and review how to use them.
For the table below, we will re-use the figures from the example above and identify which metrics require which figures to complete the calculation. As a reminder, those figures are
- Purchase Price or Market Value: $500k
- Down Payment or Equity Invested: $80k
- Up-front Expenses: $20k
- Revenue: $40k / year
- Operating Expenses: $16k / year
- Annual Mortgage Payment: $20k ($11k of Principle + $9k of Interest)
- Appreciation: 2%; as a dollar amount = $500k * 2% = $10k / year
- Taxes: Excluded since they vary by personal situation and location.
| Metric Factors | Cap Rate | Cash-on-Cash | Return on Investment |
|---|---|---|---|
| Purchase Price / Market Value | $500k | ||
| Down Payment | $80k | $80k | |
| Up-front expenses (e.g., Land Transfer taxes, legal fees, repairs and renovations) | $20k | $20k | |
| Revenue (Rental and other) | $40k | $40k | $40k |
| Operating Expenses (e.g., property taxes, utilities, maintenance, etc.) | $16k | $16k | $16k |
| Mortgage or Loan Principal | $11k | $11k | |
| Mortgage or Loan Interest | $9k | $9k | |
| Market Value Appreciation | % estimate of 2%, which is $10k | ||
| Year-over-Year Changes | % estimates used for long-term analysis |
When comparing side-by-side, you can see how Cap Rate uses the least amount of inputs, Cash-on-Cash is in the middle, and ROI uses the most inputs.
How Do I Pick The Right Real-Estate Metric For The Right Time?
Now that you know the definitions and figures for calculating Cap Rate, Cash-on-Cash, and ROI, let’s review when these real estate investment metrics are most applicable.
| Factor | Cap Rate | Cash-on-Cash | Return on Investment |
|---|---|---|---|
| Description | Evaluates the first-year returns, excluding any costs associated with mortgages or loans. | Cash-only metric that considers the cash invested upfront versus the net cash flow in the first year of operations. | A broad and deep metric that considers the total gain or loss from an investment over a period of time, based on the equity invested. |
| Time Frame | First Year focused. | First Year focused. | First year and long-term. |
| Complexity | Low: The least amount of inputs are needed for the calculation. | Medium: More inputs are needed to build the cash flow figures. | High: The most inputs are needed, including assumptions of expense and change over time. |
| Formula (shown as a %) | (Net Operating Income) / (Market Value) | (Net Cash Flow) / (Total Cash Invested) | (Start-up Expenses +Operating Cash Flow -Mortgage Interest +Mortgage Principal +Price Appreciation) / (Equity Invested |
| Benefits | – Fast calculation when comparing multiple properties. – It provides a simple calculation to quickly vet the operational returns before diving into deeper debt and leverage calculations. – If buying cash, then the return is reasonably accurate. | – Provides an immediate understanding of your cash benefits. – A positive Cash-on-Cash return indicates that the Cap Rate and ROI may also be positive. – High accuracy as you deal with cash figures over a short period. – Takes into account all upfront costs. | – Provides a long-term method to estimate your returns. – Takes into account changes to your rent, expenses, and property value over time. – Uses the highest amount of inputs, thereby providing a more comprehensive calculation. – Takes into account all upfront costs. |
| Drawbacks | – First-year focused, not ideal for measuring performance over time. – It ignores debt or how you finance the property. – Ignores upfront start-up expenses since those are separate from the net operating income. – Assumes you buy cash. – A positive Cap Rate does not mean you will be cash flow positive once you account for financing. | – First year was focused, which is not ideal for measuring performance over time. – It doesn’t help you estimate long-term returns. | – Assumptions for long-term changes (i.e. rent, expense, appreciation) may vary greatly from the estimates. – Annual appreciation can skew the returns and may be misleading if not reviewed alongside cash flow. – A positive ROI does not imply that you will be cash flow positive. – You need to make a long-term mortgage rate assumption for 5 and 10-year estimates, which is hard to predict. |
| Ideal Use Cases | – Great starting metric when narrowing down and filtering for investment options worth diving into. – Understand the pure day-to-day operating view of the investment. – Quickly do side-by-side comparisons to find the best opportunities. | – When analyzing multiple properties for investment research. – Checking if your cash flow is positive upfront before diving in deeper. | – Best metric to compare the alternative investments (e.g. Stocks) because ROI is a cross-investment metric. – Ideal when you’ve narrowed your search to select properties. – You need to understand the long-term investment implications. – Comprehensive analysis of all possible factors when making an investment decision. |
Understanding the scenarios for these real estate investment metrics helps you understand what they mean in isolation. Using them collectively will naturally be the best option.
In most cases, calculating these metrics would be time-consuming and tedious and require you to build out and validate your calculations manually. Alternatively, you would pull it together through different websites and calculators.
However, with the openly available BusinessCaseGuy.com real estate investment calculator, you can easily plug in your numbers, review the results of all these metrics (and more) and email yourself a copy. Let’s go through a real example using all freely available tools.
Calculate a Real World Scenario to compare Cap Rate, Cash-on-Cash, and ROI
Let’s move on to practical examples to illustrate how these metrics work in real-world scenarios and prepare the analysis in 3 easy steps.
1. Identify a property
Estimating a realistic market value for purchase and rental prices can be done through real estate agents, bank appraisals, or by researching other recent and comparable sold listings. Tools like Zillow (US) or House Sigma (Canada) are great research tools because they show you the actual sold and leased prices.
In this search example, I found the property just west of a university campus in Austin, Texas.
2. Find or Estimate the Input Values
Another great feature of Zillow.com is that it helps you estimate the rent, the various expenses, and the expected sale price. Below are two screenshots pulled from the same listing.
Sale Price and Rent Estimate
Monthly Expense Estimates
3. Plug the Values into the Calculator
The next step is to plug the figures below into the BusinessCaseGuy.com real estate investment calculator. In addition to the information from Zillow, you will need to add additional estimates.
The items with a (*) require your estimates or inputs. For a detailed dive to understand all these figures and building estimates, review the comprehensive 12-step guide to buying investment properties.
- Purchase Price or Market Value: $417,200 (Based on the Zillow estimate)
- Down Payment or Equity Invested: 25%, $104,300
- *Legal and Regulatory fees: $2,400
- *Renovations and Repairs: $1,200
- Other Fees: $800
- Land Transfer Tax: $0 (None in Texas, wow!)
- *Annual Property Growth Rate: 2%, $8,360
- *Mortgage Interest Rate: 4.5%
- *Amortization: 30 years
- Rent Estimate: $2,294 / mo.
- Property Taxes: $523 / mo.
- Maintenance / HOA Fee: $411 / mo.
- Home Insurance: $146 / mo.
- *Repair Allocation: $20 / mo.
- *Property Management Fees: $0
- *Occupancy Rate: 100% (expected a high occupancy as it is a university town)
- *Fee to find a tenant: $0 (adjust if you are using an agent)
- Utilities: $0 (paid by the tenant)
- Income Taxes: Excluded since they vary by personal situation and location.
- Growth Rate: 1%-2%. The calculator has a column to estimate the annual increase in your rent and expenses. You can adjust the values as needed.
All done! Let’s review the results in the next section.
The Results: Cap Rate vs. Cash-on-Cash vs. ROI
After plugging in the available information, which took less than 3 minutes, we can utilize the Investment Dashboards and results from the Investment Property Returns Calculator to help understand how each metric was calculated and what they mean.
The Real Estate Investment Dashboard
The metric results are highlighted in yellow, and there are significant variances from the lowest return to the highest. They range from -4.3% to +9.0%, 13.3% across these three metrics. How can metrics for a single investment property vary by over 13% and have negative and positive returns? Let’s dive in.
We’ll use the information from the calculator’s ‘Business Case Summary’ section to show each metric’s calculation. Using the ‘Equity Summary’ table figures, you can perform each calculation independently. When calculating, use all the numbers in the ‘positive’ format (i.e. no negatives). They are only shown as negative from the point of view of an increase or decrease in equity.
Capitalization Rate Results
We will use figures from the ‘Equity Summary’ table. Note that ‘Net Operating Income’ is used interchangeably with ‘Operating Cash Flow’. Here are the calculation steps, expressed as a %.
- Cap Rate = (Net Operating Income) / (Market Value)
- Cap Rate = ($14,328) / ($417,200)
- Cap Rate = 3.4%
The positive Cap Rate informs us that if we are not using any debt, the return is positive from an operating point of view and the property can support itself assuming you were paying all cash. However, if debt financing is part of your plan, we must move on to the Cash-on-Cash metric to learn more.
Cash-on-Cash Return Result
Also pulling from the ‘Equity Summary’ table above, here are the calculation steps, expressed as a %.
- Cash-on-Cash = (Net Cash Flow) / (Total Cash Invested)
- Cash-on-Cash = (Operating Cash Flow – Mortgage Interest – Mortgage Principal) / (Down Payment + Start-up Expenses)
- Cash-on-Cash = ($14,328 – $13,977 – $5,048) / ($104,300 + $4,400)
- Cash-on-Cash = (-$4,697) / ($108,700)
- Cash-on-Cash = -4.3%
The negative Cash-on-Cash return shows that once you take on a mortgage, the principal and interest payment will turn cash flow negative. This helps explain why you see a positive Cap Rate but a negative Cash-on-Cash return.
If positive cash flow monthly or annually is your priority, this is not an ideal investment. If you are still interested but need positive cash flow, consider reducing your offer price, increasing your down payment amount, searching for higher rent, or finding ways to reduce expenses.
Let’s move to the ROI result and find out why it is positive, even though cash flow is negative.
Return on Investment (ROI) Result
Using all the figures in the ‘Equity Summary’ table above, here are the calculation steps, expressed as a %.
- ROI = Equity Growth / Equity Invested
- ROI = [ (Start-up Expenses) + (Operating Cash Flow) – (Mortgage Interest) + (Mortgage Principal) + (Price Appreciation) ] / (Equity Invested)
- ROI = [ (-$4,400) + ($14,328) – ($13,977) + ($5,048) + ($8,344)] / ($104,300)
- ROI = [ ($9,343) ] / ($104,300)
- ROI = 9.0%
So how do we explain a positive ROI (+9.0%) but a negative Cash-on-Cash return (-4.3%)? Doesn’t ROI take into account cash flow? The answer is yes, it does. However, ROI also adds back your mortgage principal since that builds your equity and considers your property’s estimated annual appreciation. Those two items add $13,392 ($5,048 + $8,344) to your equity.
Long-term ROI Impacts and Results
The added benefit of using the ROI metric is that you can continue to use it annually to estimate long-term returns. Usually, those would be difficult estimates to build; however, if you dive deeper into the income property calculator, you will see ROI estimates over 5 and 10 years that consider assumptions of rent increases, changes in expenses, and your estimated average mortgage rate over 5-10 years.
For the same scenario, here are the 5 and 10-year estimates as dollar figures as a %. With no additional effort, the real-estate investment returns calculator provides the estimates with the numbers you inputted earlier.
Long-term ROI Estimates by $
Long-term ROI Estimates by %
Summary: Cap Rate vs. Cash-on-Cash vs. ROI
Which Metric Should I Use?
These three metrics tell you different things about a real estate investment opportunity. As helpful and specific as they are individually, using them collectively is the ideal scenario. Starting with an understanding of the daily operating costs (Cap Rate), then working through debt financing and all-in cash flow impacts (Cash-on-Cash), right through to an in-depth short and long-term analysis (ROI).
It’s no secret that the best-case scenario is when all three metrics show positive numbers, and the higher the returns, the better. However this is not easy to find, and having a calculator that only takes a few minutes to complete, can help you run the numbers and make informed decisions.
Is a Real Estate Investment Worth It?
This is a big question, and you need to understand your alternatives to real estate. The most common alternative and recommended option is investing in stocks through an S&P 500 ETF. For an in-depth understanding, read the Ultimate Guide to Calculate Stock Market vs Real Estate Returns or take some time to understand the 16 Pros and Cons of Investing in Real Estate.
Once you understand the stocks vs. real estate debate, you must understand what ROI is worth it. Is it 6%, 12%, or 20%? The reason for using ROI is because that is a common cross-industry metric. This means you can compare a stock market ROI to a real estate investment ROI, as calculated in this Real Estate vs Stock Market calculator.
Risks when using Real Estate Financial Metrics
Investors must recognize that any financial metric has inherent risks and uncertainties. Here are key points to consider when interpreting Capitalization Rate, Cash-on-Cash Return, and Return on Investment.
- Estimates, Variability, and Forecasts: All calculations are estimates, and results may vary. Market conditions, unexpected expenses, and other factors can influence returns.
- Reality May Differ: While metrics provide a theoretical understanding, real-world scenarios may differ. It’s essential to remain vigilant and adapt strategies based on actual performance.
- Downside Risk: Investors should know the downside risk associated with their investments. Analyzing for the worst-case scenario analysis and stress testing can help mitigate potential risks.
- Limitations of Metrics: Recognize that these metrics are tools for analysis, not guarantees of success. They offer insights into specific aspects of an investment but need to be analyzed with other metrics and considerations.
By acknowledging these risks and limitations, investors can approach their analyses with a balanced perspective, making informed decisions that align with their financial goals and risk tolerance.
Disclaimer
This guide is for informational purposes only. It is not meant to decide for you. All figures are inputted based on your best estimate and can fluctuate based on the variety of risks outlined. BusinessCaseGuy.com is not responsible for the outcomes, good or bad, of any decisions made using this guide. Please review your financial choices with your financial advisor, real estate agent, accountant, or qualified professional.
