What is Cap Rate (Capitalization Rate)? What is Cash-flow?
What is Cap Rate?
Simply put, Cap rate is the percentage of return from an investment based on the income the property is expected to generate. It is calculated when you divide the NOI (Net Operating Income) by the total acquisition costs (or the price paid for the property).
The purpose of finding the cap rate when it comes to real estate investments is to measure how well an investment is performing. It is also used to compare one investment to another.
To find the cap rate of an investment, divide the NOI (Net operating Income) by the price paid for the property (or total acquisition costs).
Cap Rate = NOI/Price Paid for Property
Example: $5,000 (NOI)/ $100,000 = 5% Cap Rate
If an investor is considering selling his/her investment, the current market value of the property is then factored into the equation, rather than the price that was originally paid for the property.
Example: Now let’s say that our property in the previous example has appreciated, and is now valued at $200,000.00. To find the cap rate of our investment, at its current market value, we would calculate the following:
$5,000 (NOI as we have not increased the rents) / $200,000 (current market value)
$5,000/$200,000 = 2.5% Cap Rate
Determining the cap rate is a value indicator for an investor. The higher the cap rate, the higher the return. Higher cap rates are also considered to higher risk, and less desireable.
The lower the cap rate, the lower the return. A lower cap rate is usually more desirable as the risk is likely to be lower.
What is Cash Flow?
Cash Flow, Return on Investment (ROI), and Cash on Cash Return… all three terms with the same meaning.
Once you’ve determined cap rate, and net operating income you can take it one step further by calculating the cash flow. It is the ratio determining the cash flow (or ROI) on an investment that will produce a percentage rate that measures the received, pre-tax cash flow (for the year) relative to the amount of cash invested. Basically the amount of money remaining after paying the Debt service (annual mortgage amount).
The formula to determine your ROI is as follows:
Cash-on-Cash = Annual Pre-Tax Cash Flow
Return Actual Cash Invested
In the cash on cash formula above, the cash on cash return is a simple measure of investment performance that is calculated as cash flow (before taxes) divided by the initial equity investment.
Example: Let’s say that our investor purchases a property, at $500,000. He generates $100,000 a year in rents, laundry and other income. He obtained a loan in the amount of $125,000 with $375,000 as a down payment.
$500,000 (purchase price) – $125,000 (loan amount) = $375,000 (cash invested)
$100,000 (pre-tax cash flow) – $8,052* = $91,948 (annual pre-tax cash flow)
$91,948/$375,000 = 24.5% Cash-on-Cash Return
|* To determine the annual loan payment, calculate the monthly loan amount (including principal and interest) by 12 months. This monthly loan amount is to be determined by the lender by factoring the terms of the loan.|
If you’re an investor seeking professional representation in retail, multi unit, and industrial investments, contact Simon Asef of DMC Real Estate.
Broker | Investment Advisor
DMC Real Estate | License #01726727
Tel 818.761.4252 ext. 102 | Fax 818.505.9152