Cap Rate vs. Cash on Cash Return: What is the Difference?
The Cap Rate and Cash-on-Cash Return are two common return metrics in commercial real estate (CRE) used to measure the viability of a rental property investment.
The primary distinction between the two return metrics is that the cap rate is an unlevered metric, while the cash on cash return is a levered metric.
What is the Difference Between Cap Rate and Cash on Cash?
In practice, real estate investors often analyze the potential rate of return to expect on a rental property based on the cap rate and cash-on-cash return (CoC) metrics.
- Cap Rate → The cap rate, or “capitalization rate”, measures the potential yield earned on a rental property investment while neglecting the usage of leverage.
- Cash on Cash Return → In contrast, the cash on cash return, or “cash yield”, represents the profit earned per dollar of equity invested into a rental property.
Like the cash-on-cash return, the cap rate represents the annual rate of return on a rental property investment and is expressed as a percentage.
However, the financing structure of the investment — the percentage of debt and equity used to fund the purchase price — does not affect the cap rate (i.e., it is capital structure independent).
Conversely, the cash-on-cash return (CoC) is directly influenced by the percentage of leverage used to fund the investment.
Therefore, the difference is that the cap rate is an unlevered metric independent of financing, whereas the cash on cash return is a levered metric affected by the percent reliance on leverage.
Cap Rate vs. Cash on Cash Return: Formula Comparison
Formula to Calculate Cap Rate
The capitalization rate is the annual rate of return on a property investment calculated by projecting its pro forma net operating income (NOI) at stabilization and dividing the metric by its current market value.
Formulaically, the cap rate is the ratio between stabilized NOI and the current market value of the property, expressed as a percentage.
Where:
- Net Operating Income (NOI) → The net operating income (NOI) of the property is the sum of its rental income and ancillary income, which is then deducted from its direct operating expenses.
- Current Market Value (CMV) → The current market value of the property, on the other hand, is most often the purchase price of the investment (or asking price).
The cap rate measures the risk-return profile on a property rental investment, so a higher percentage implies a higher potential return (or more downside risk).
Comparing the implied cap rate of a property investment to the prevailing market cap rate of comparable properties is a practical method to determine which investment opportunity presents the most attractive risk-return trade-off.
Formula to Calculate Cash on Cash Return
The cash-on-cash return, or “cash yield”, measures the annual yield earned on the initial equity investment.
The cash-on-cash return is the ratio between the annual levered pre-tax cash flow and the equity investment on the date of the initial purchase.
Where:
- Annual Pre-Tax Cash Flow = Net Operating Income (NOI) – Annual Debt Service
- Initial Equity Investment = Property Purchase Cost – Total Loan Amount – Non-Equity Financing
The annual pre-tax cash flow is the net operating income (NOI) of the property remaining after deducting the annual debt service.
- Net Operating Income (NOI) = (Rental Income + Ancillary Income) – Direct Operating Expenses
- Annual Debt Service = Principal Amortization + Interest
The composition of the equity investment is predominately the cash down payment, followed by fees related to closing costs, repairs, or property upgrades (or renovations).
Like most levered metrics, the cash yield can easily be distorted by the percentage of leverage used to fund the purchase, making comparisons to peers challenging.
If the proportion of debt in the total purchase price rises, the required equity contribution declines, causing the cash-on-cash return to increase – all else being equal.
The utility of the cash-on-cash return metric is that the metric considers the financing structure of a potential investment (i.e., the effect that debt will have on returns).
In comparison, the capitalization rate is the expected return on a rental property investment, neglecting the funding structure of the initial purchase.
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Enroll TodayCap Rate vs. Cash Yield: Comparative Analysis
The cap rate on a rental property investment is determined by dividing the property’s annual net operating income (NOI) by its current market value.
Contrary to the cash-on-cash return, however, the cap rate is unaffected by financing (i.e., it is capital structure independent).
Conceptually, the cap rate can be perceived as the unlevered cash-on-cash return (CoC) on the date of the original investment.
The numerator in the cap rate formula is net operating income (NOI), an unlevered profit metric unaffected by discretionary financing decisions. Since the numerator and denominator must be consistent for the metric to be functional, the market value of the property (or purchase price) is used.
The cash-on-cash return measures the annual pre-tax cash flow received per dollar of equity invested.
Unlike the cap rate, the cash-on-cash return is a levered metric (i.e., post-financing) because the numerator is the annual pre-tax cash flow.
Likewise, the equity contribution is also a direct function of the total amount of debt used to fund the purchase (i.e., loan-to-value ratio).
Cap Rate vs. Cash Yield Calculator
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Cap Rate vs. Cash on Cash Return Calculation Example
Suppose we’re tasked with calculating the cap rate and cash-on-cash return for a commercial rental property investment.
The potential gross income (PGI) is the maximum income that could be derived from the property without adjusting for any losses.
- Potential Gross Income (PGI) = $2 million
The vacancy and credit losses are deductions from the PGI to account for unoccupied units, and foregone income from credit losses (i.e. uncollectable rent payments).
The vacancy loss is assumed to be 6% of PGI, while the credit loss is 3% of PGI, yielding losses of $120k and $60k, respectively.
- Vacancy Loss (6% of PGI) = ($120k)
- Credit Loss (3% of PGI) = ($60k)
The ancillary income refers to the income earned on the side beyond the rental payments from tenants, which is assumed to be $180k.
- Ancillary Income = $180k
The effective gross income (EGI) is $2 million, implying that the ancillary income offsets the vacancy and credit losses.
- Effective Gross Income (EGI) = $2 million – $180k + $180k = $2 million
From there, the next step is to deduct the cost projections to operate the property, which is assumed to be 40% of EGI, resulting in a total loss of $800k.
The net operating income (NOI) is $1.2 million, which we calculated by subtracting operating expenses from the effective gross income (EGI).
- Net Operating Income (NOI) = $2 million – $800k = $1.2 million
The annual debt service is the burden to service the borrowing of debt, which is assumed to be $800k.
Since the NOI and annual debt service have been calculated, the annual pre-tax cash flow – the income remaining after servicing debt costs – amounts to $400k.
- Annual Pre-Tax Income = $1.2 million – $800k = $400k
The cash-on-cash return measures the return on the equity investment from the perspective of the real estate investor.
Given the initial equity contribution of $5 million, the cash-on-cash return is 8%.
- Cash-on-Cash Return = $400k ÷ $5 million = 8.0%
The market value at which the property could be sold in the open markets as of the present date is $20 million.
Therefore, the purchase price of the property is $20 million, for which $5 million was contributed by the real estate investor, while the remaining $15 million was financed via loans.
The implicit assumption regarding the loan-to-value ratio (LTV) in the financing structure of the property purchase price is 85%.
- Loan-to-Value Ratio (LTV) = $15 million ÷ $20 million = 85.0%
In conclusion, the cap rate is calculated as the net operating income (NOI) divided by the property market value, which comes out to 6%.
- Cap Rate (%) = $1.2 million ÷ $20 million = 6.0%
