When to Use Real Estate Investment Formulas
Real estate valuation formulae are used to calculate the value of an investment property. There’s a plethora of formulae out there …and each one uses a slightly different method and thus arrive at different valuation results. The formulae you should use depend on the type of property you’re valuing and the questions you’re asking …whether you need to calculate loan return or cash-on-cash returns, or if you need to find out how much your property is worth for a particular purpose like an insurance claim.
The methods and assumptions that the formulae make can be hard to decipher for some people. Don’t worry, we’ll explain all the necessary calculations and formulas for determining the value of a real estate investment property …and we’ll show you when you should use the grading, appraisal, and cash-on-cash methods of evaluating a property…and when you should go with a more complex formula like the Replacement Value.
Vs. ROI vs. Cash-on-Cash Returns
As real-estate investors, we always look at the ROI in a traditional sense. We calculate the Cash-on-Cash Return to see how much cash we earn on our money when buying and selling investment properties.
The ROI in this traditional sense is well established and very familiar to most real-estate investors. However, during the last decade, the more advanced Cap Rate and Cash-on-Cash Return measures have been gaining popularity in the industry. Because each measure makes up a different part of a potential Return on Investment, investors require a general understanding of how these three economic indicators overlap.
A Cap Rate is a way to evaluate a business model. It is calculated by dividing the Net Operating Income (NOI) of a real estate property by the price per square foot of the property. Therefore, NOI equals:
- NOI = Operating Expenses “ Depreciation “ Income Tax Expenses “ Operating Cash Flow
- Cap Rate = Net Operating Income “ Price per Square Foot
Return on Investment
And Cash on Cash Returns (ROI and COCR) lets you quantify long term success of a real estate investment. You can calculate it from the first unit sold…to the last unit sold. It measures the income positive cash flows from a piece of real estate.
If you are not familiar with this. COCR is Net Operating Income before vacancy, taxes, property management, advertising, and commissions.
Thus if the property has Net Operating Income of 10% and have no vacancies, the COCR for the year is 10%. And if the property does not have tenants then there will be an expense for property management. The COCR will remain the same though, because it is being spread out over the whole year.
This will show the return when Net Operating Income remains the same. However if Net Operating Income rises, the property will actually have a better COCR, i.e. the property is making more income. This also shows that COCR should not be looked at once in a while.
It has to be calculated based on the whole year…the same way as your Cash Flow from Operations is a good metric (usually quarterly) to measure your profitability.
The cash-on-cash return is the single most important return analysis ratio for real estate investors. It is a comparison of the annual cash flow from your monthly cash expenses (down payment, mortgage payments, maintenance and various other expenses) to the amount it cost you to purchase the investment property. It’s important to realize that the cash-on-cash return is an annual rate, not a monthly rate. And it’s calculated at the end of each month.
A positive return indicates that the property is generating more cash for you than it is costing you to own it. This can occur if the monthly cash flow is greater than the total purchase price. Alternatively, a negative cash-on-cash return indicates that the property is costing you more in cash expenses each month than it is generating in cash flow.
You should prefer investments with positive cash-on-cash returns over investments that do not generate enough cash to cover their expenses. A two percentage point (2%) return is the industry benchmark for cash-on-cash positive results.
A property that is Cash-on-Cash Negative or with a 0% return may yield a good return if there is significant collateral value or if it can pay for itself through property improvements in a reasonable amount of time.
Cap Rate vs. ROI vs. Cash-on-Cash Returns
A Real Estate Investors Guide
Cap rate is the most commonly used metric for evaluating real estate investment properties, yet many investors don’t actually understand its meaning and proper application.
Investors will frequently use capitalization rate or cap rate (the term cap rate comes from the phrase capitalization rate) to compare properties, and determine which property is a good investment and which is a poor one … and often times they do this even though they have no actual understanding of what cap rate is or what it’s meant to measure.
In this post, I’m going to provide the reader with a crash course on cap rate, its proper interpretation, and answer the three most frequently asked questions concerning it. If the reader can’t determine whether a property is a good investment or a poor one based on its cap rate, then this post will be useful to him or her.
Cap Rate Definition
Cap rate (sometimes called capitalization rate or capitalization ration) is a summary financial statement of an investment property… it’s simply the rate of equity return (also known as cash-on-cash returns) the property generates. In the simplest form, it’s calculated as follows:
How to Calculate Cap Rate on an Investment Property
Cap rate, or capitalization rate, is a calculated estimate of the return on an investment property. It’s like an annualized rate of return, but it’s calculated on an entire investment property, not just one or two years.
As a business owner, I’m always on the lookout for ways to increase my bottom line and come up with ways to maximize the value of my investment. One of the basic ways to do this is to increase my cash flow from the investment property.
Increase Cash Flow
To that end, I need to maximize my income from the property. One way to accomplish this is to increase the rent.
But before I can increase the rent, I need to know how much I’m collecting in rent each month. For that, I need to know what I’m actually getting in rent. This is where the cap rate comes in.
Cap Rate Is a Great Way
Cap rate is similar to net operating income, which is another term that’s used in the real estate investing community. Both cap rate and net operating income are used to calculate the cash available from an investment property.
Net operating income is your cash flow, or income you generate, from an investment property, before any expenses are taken into account.
How to Calculate ROI on an Investment Property
When you’re considering buying an investment property, cash-on-cash return is one of the most important metrics to keep in mind. Here’s the formula to calculate it:
Cash-on-Cash Return (ROI) = Net Cash Flow (NFCF) / Cash outlay
NFCF is calculated by taking all the money you’ve invested in your investment property and subtracting what you earn from it. Cash-on-Cash return is much more complicated than it seems on the surface, and there’s more to it than just putting in your cost of investment and dividing it by your cash outlay. Before we dig in, let’s take a quick look at the numbers.
How to Calculate Cash-on-Cash Returns on an Investment Property
Finding properties to flip is an important part of the real estate investing process. The problem is, flipping can be a little time-consuming and tedious, and it’s not exactly the most profitable way to invest. But if you know how to calculate cash-on-cash returns on an investment property and how to separate the good from the bad, then you can feel more comfortable about the risks that come with flipping a property.
Cash-on-cash returns are calculated by dividing a property’s Net Operating Income (NOI) by its selling price. The ratio of the property’s sales price to its original investment price is what defines its cash-on-cash score.
The higher the percentage, the better the cash-on-cash returns and the more the property can be viewed as a cash-producing property, rather than a capital-intensive property. Cash-on-cash ratios range from the mid-50% to as high as 85% but should be less than 90%.
If you’re still unsure how to figure out a property’s cash-on-cash ROI, here are a few tips for calculating, based on actual case studies:
Calculate ROI by dividing a property’s NOI by the property’s purchase price.
Cash-on-Cash Returns Formula
Cash-on-Cash Return (COCR) Formula: COCR = Cash Flow/Cash Invested.
The formula for calculating return on your capital investment (ROI) is as follows:
ROI = Cash Flow/Cash Invested
The cash flow metric is usually assumed to be the Net Operating Income (NOI). In reality, it can be a Net Operating Income (NOI) plus or minus any depreciation, vacancy and/or management fees. The actual NOI will be informed by your particular accounting system.
COCR Formulas for Real Estate Investments
Cash on Cash Return – MATR (most common) = Net Operating Income – Investment. Cash on Cash Return – ROI = Net Operating Income/Investment. Cash on Cash Return – Cap Rate (recently) + Net Operating Income = Net Operating Income.
Experienced real estate investors will recognise the use of these formulas as a way to calculate return on investment (ROI) specifically for real estate. It’s not uncommon for investors to compare various types of investments, such as hard assets (that is, those that physically exist and can be converted into money) to soft assets (such as those in real estate or other aspects of a company).
Pro Tips on Using Cap Rate vs. ROI vs. Cash-on-Cash Returns Formula
Using Cap Rate vs. ROI vs. Cash-on-Cash Returns Formula
Cash on Cash returns can function as an effective depreciation formula, which compares the cash flow with the original cost of the property. Also, ROI can be used to determine the profit generated per year. However, figuring out Cap Rate can be tricky and often confusing.
That’s why many investors find themselves in the dark.
That’s why Cash Flow vs. CFFO or Net Operating Income vs. NOI might be the perfect formulas to catch a bird in the hand, instead of waiting for the other one to fly by.
Cap Rate Vs. ROI Vs. Cash-on-Cash Returns
Cap rate can be roughly defined as –the net income from property minus expenses on that property, divided by the property’s cost,” as per Investopedia. Net Income or NOI is usually calculated as rent expense – minus operating expenses – minus vacancies — divided by the square footage in the property.
Use Cap Rates to Compare Similar Properties
Cap rates are often mis-used or misunderstood, and I’ve even seen some investors have conflicting opinions about what cap rates really mean. This can make it difficult to determine if two properties are truly comparable or not. So, in order to get a better picture of what cap rates truly are, we need to do a better job of understanding what they’re trying to tell us.
For this reason, we’re going to take a closer look at the three common uses cap rates are put to. Once we have a clearer understanding, we can then get into the details to determine if two properties are truly similar. And if they aren’, we can work with them to uncover their true comparative value.
Use the Same Calculations to Compare Real Estate Investments
So you’ve decided to invest in real estate and are looking to choose a real estate investment property. By now, you’ve heard about the various metrics real estate investors often use to compare investment properties. The most well known and controversial metrics are Cap Rate (Net Operating Income – NOI – divide by the mortgage interest expense), Cash-on-Cash Returns, and Return on Investment (ROI).
Cap Rate vs. ROI vs. Cash-on-Cash Returns
To help investors identify the best properties, many real estate investors use Cap Rate, ROI and Cash-on-Cash Return. However, unfortunately, each property is unique and does not operate in a vacuum. As such, although Cap Rate, ROI and Cash-on-Cash Return are great guides to compare properties, there is no guarantee that similar properties will produce similar rates of return.
Cap Rate vs. ROI vs. Cash-on-Cash Returns: A Simple Example
To better understand the differences between Cap Rate, ROI and Cash-on-Cash Return, let’s look at an example. Assume that you have the opportunity to invest in two different properties, A and B, as a passive investor.
Use a Combination of Investment Formulas to Compare Properties
I was on an extensive analysis of cash-on-cash returns with a client recently, and it’s easy to become confused in the process. There are so many formulas out there to help you analyze investment real estate in different ways. Confused? Don’t worry, every real estate investing professional gets confused at times about the different combinations of formulas and exactly how they are being applied. As part of preparing to invest in real estate or to make an offer on a piece of investment property, it’s important to take a closer look at the math based on a combination of formulas to help you understand the rate of return on your investment.
Here’s a breakdown of the common formulas used in the real estate investing industry and how they are best applied.
Cash on Cash (CoC) Return- One of the most popular formulas used to compare investment properties is the cash on cash return. This formula calculates how much money you will pocket if you establish a one time payment of principal and interest on your investment. This property can be a single family home, condominium, single family residence, or commercial space.
Cap Rate vs. ROI Frequently Asked Questions (FAQs)
What Is a Good Cap Rate?
What Is the Cash-on-Cash Return Formula?
If you are new to real estate investing, chances are you are wondering why you would ever need a cash-on-cash return formula. Sure, you are in business to make money, and making money is as simple as working hard and squeezing out a little more every month, but you are not really into doing the math. No need to worry, however. Because this is a brief article that goes over what a cash-on-cash return formula is and how it can benefit you, not just financially but also in terms of time.
If you struggle with the basics, a cash-on-cash return formula will not help you, so you’ll want to skip ahead to the next section for an overview of just what a cash-on-cash return formula is and why you should give it a try.
How to Calculate ROI on a Fix-and-Flip Project?
What Is a Cap Rate Calculator?
Cap rate is the annual percent rate at which a property.
The rate is calculated by multiplying the property’s total value by its net operating income (NOI) – the annual net rent minus the annual property taxes.
The cap is a handy, quick way to compare real estate investments by determining whether one property is worth more or less than another.
Since cap rates are calculated by dividing total value by NOI, they are also known as Multiples of Operating Income. In addition to being one of the basic financial metrics used in real estate valuation, cap rates are used in analyzing bank loans for potential investment acquisition, sales comparisons, and for determining a property’s lease rate index.
Cap rate yields can be used to compare the risk associated with potential properties. Cap rate and discount rate yields also fluctuate based on property type, market conditions, and total portfolio value.
For example, pursuant to an accounting rule change, the financial impact of debt forgiven on an acquisition or refinancing may be included in NOI, thereby increasing NOI despite the property’s underlying financial performance in the transaction. For more information, refer to IRS Form 1065, U.S. Income Tax Return for Estates and Trusts, Section 7, Balance Sheet (T1) to locate the list of defined terms and their associated definitions.
The Bottom Line
A Cap Rate has nothing to do with the amount of hair enjoyed by Neil deGrasse Tyson. It’s a specific type of return on investment and is a measurement that investors use to determine the return on their investment.
ROI, or Return On Investment, is calculation used to determine the profitability of a company, real estate investment property or estate sale. It is also known as net operating income, and it’s expressed as a percentage. An ROI is determined by dividing the net property income (if the property we own is a rental property) or the net cash flow (if the property we own is a business) generated by the property by the total cost of the property.
Cap Rate is the ratio of the total amount of income obtained by an investor on an investment property or project to the total invested amount. So if a 5% cap rate is sold to a buyer, the property is worth 5% of the original cost to the buyer. Therefore, the property is worth at least 3.5% of the original cost.
Note that cap rates do not compare the value of one property to another. Instead, they are intended to compare the relative value of one investment property to its peers.
The difference between cap rate and ROI is as follows: