Important Calculations for Rental Property Investors
CAP Rate and Cash on Cash Return are two of the most important and widely utilized Return on Investment (ROI) calculations that seasoned investors use to make decisions on whether or not to invest in a piece of property. They are both a quick calculation that can be made as a desktop analysis on a property quickly. An investor can realize quickly whether more due diligence is worth their time. Both help an investor make the decision to pass on an opportunity or seize it before another investor sweeps it up from underneath them.
CAP Rate
CAP Rate or Capitalization Rate, is one of the first ROI calculations an investor makes in order to decide if even seeing the property is worth it. There are several items that a CAP Rate takes into account, none of which are debt service (or mortgage on a property). These items are the Income, Expenses, Net Operating Income, and Sales Price. CAP Rates differ based upon an area and the CAP Rate an investor is willing to accept is a personal decision by that investor.
Income is fairly straightforward. It is the annual revenue that a property will generate based upon the local rents for comparable units in the market. The expenses, though, are a bit different. They include both objective and subjective expenses. The objective expenses are taxes, insurance, renovation, and management fees on an annual basis. The subjective expense is vacancy, or period of time when a property has a portion of time not rented. The standard calculation for vacancy is 10%. The management fees can also be subjective, as they differ depending on the market that the property is in but, generally are between 8-10% of the annual revenue of the property. Finally, any renovations necessary on a property also enter into the equation as expenses for the initial year.
Initial CAP Rate focuses on the first 12 months, after renovations are completed and a tenant is in place, of a property’s operation. Maintenance is not a factor in the initial year, except for in unpredictable circumstances, because, these items are addressed during the initial renovation period. Though, maintenance is often calculated as a dollar amount or percentage of revenue in operational year 2 and thereafter.
The following is an example of CAP Rate based upon a 4-Unit property that we recently sold (The Property was sold for $120,000 but, we will use $119,900 (the offer price) in this example):
Income: $28,800
Expenses:
Taxes: $2,091
Insurance: $2,000
Management (10%): $2,880
Vacancy: $2,880
Total: $9,851
Net Operating Income (NOI):
With Mgmt: $28,800 – 9,851 = $18,949
W/O Mgmt: $28,800 – 6,971 ($2,880 added back) = $21,829
CAP Rate (Sales Price + Initial Renovation ($5,000)):
With Mgmt: $18,949/$124,900 = 15%
W/O Mgmt: $21,829/$124,900 = 18%
Cash on Cash Return
Cash on Cash Return is very similar to CAP Rate but, has one distinct difference, it is calculated based upon the amount of initial cash outlay that an investor makes. In other words, if an investor obtains financing for a property, the cash on cash return is based solely on the amount of money the investor puts down, not on the sales price of the property.
Using the same example as above but, assuming that the investor put $25,000 down (for simplicity) and that renovations were obtained from the loan, the following shows what the cash on cash return would be for the property, in the first 12 months of rented operations:
Income: $28,800
Expenses:
Taxes: $2,091
Insurance: $2,000
Management (10%): $2,880
Vacancy: $2,880
Debt Service (30 years 7% interest): $7,980
Total: $17,831
Net Operating Income (NOI):
With Mgmt: $28,800 – 17,831 = $10,169
W/O Mgmt: $28,800 – 14,951 ($2,880 added back) = $13,849
Cash on Cash Return:
With Mgmt: $10,169/$25,000 = 41%
W/O Mgmt: $13,849/$25,000 = 55%
Recap
As you can see from the two examples, the CAP Rate and Cash on Cash Return of a property can help an investor make a quick and solid decision on whether a property is a good investment for them and whether more due diligence is necessary. Based upon the strategy of the investor, he knows what he will do with the property. If he is worried about the market and wants the ability to obtain his cash back quickly, he may choose to pay cash for the property and have the potential to be able to tap his equity in the property, at a time of his choosing. If the investor is only looking for long-term investments, the investor would be much better off obtaining financing, as after the first two years or so, he would have received all of his initial investment back and would continue to make $10,169 or $13,849 a year thereafter until the debt service was paid off.
For more info on CAP Rates: Click Here for the Wall Street Journal
For more info on Cash on Cash Return: Click Here for a Wikipedia Article
To see the property used in this example: Click Here