Capitalization rate (or cap rate, its more friendly name) is a rate of return used in real estate investing to determine the present value (price) of a real estate investment based upon its future benefits (net operating income).

Although cap rate alone does not provide a true picture of a property’s profitability, because it provides a quick first-glance look at a property’s ability to pay its own way, it is one of the most popular returns used for real estate investing.

Real estate agents, appraisers, investors, property tax assessors, and others that evaluate real estate investment property typically all use cap rate in one form or the other.

How Cap Rate is used for Real Estate Investing

In practice, you will use capitalization rate to express the relationship between a property’s value and its net operating income for the current or coming year.

As a result, you can use the cap rate formula to achieve three useful purposes.

1. You can compute a property’s cap rate. When you want to know the cap rate for, say, a recently sold property, you would use that property’s net operating income and sale price to determine the cap rate it sold for.
2. You can transpose the formula and compute a property’s estimated value. In preparation for a listing presentation, for instance, you can use the net operating income you estimate for that property and the cap rate for a similar, recently sold property to suggest a price.
3. You can transpose the formula again and compute a property’s net operating income. In cases where you are given a specified price and cap rate you can determine what the net operating income should be.

Here are the formulas:

1. Cap rate equals net operating income divided by property value
2. Property value equals net operating income divided by cap rate
3. Net operating income equals property value times cap rate

Understanding the Role of Net Operating Income

Net operating income is one of the most important calculations you will make concerning any real estate investment and the key to the cap rate formulations.

Therefore, it is crucial that you understand net operating income and the role it plays in making capitalization rate such a popular real estate investing return.

Mathematically, net operating income is a property’s gross operating income less the sum of all operating expenses. Why is it important? Net operating income represents the amount of money available to make the mortgage payment.

In other words, because cap rate measures the ratio between the money available for loan payment and sale price—essentially revealing whether a real estate investment will pay its own way–real estate investors and banks typically compute it.

To calculate net operating income correctly though, you must be clear about the operating expenses. Be sure to include everything considered an operating expense like property taxes and repairs and maintenance, and yet avoid adding what are not true operating expenses like loan payments and depreciation.

If you are not sure about correctly calculating net operating income, befriend a real estate specialist or purchase a quality real estate investment software or real estate investor software solution that will help you do it correctly.

Conclusion

Here are a few parting words about capitalization rate you might find useful.

There is no such thing as a universal capitalization rate–it depends on individual market areas. What might make a rental income property a steal in one city or state at a 5% cap rate, might not get a second look in another.

Cap rate can provide an assessment and comparison of investment properties, but you should never rely on cap rate alone to provide a true picture of a property’s profitability or make a real estate investing decision without correctly computing all the numbers, rates of return, and cash flow scenarios.

Remember that numbers can be manipulated. When you are being told how great a buy an income property is based upon its cap rate, be sure to reconstruct your own raw data to insure that all is revealed and nothing is concealed–before you actively pursue the real estate investment further.

Finally, expect to find capitalization rate in an APOD. Quality real estate investing software solutions will calculate it here, and now that you understand what it means for real estate investing purposes, you should begin to look for it.

A number of years ago my father’s garage caught fire and virtually burned to the ground.

Luckily, he did have a good insurance policy for the house and got a new garage; unfortunately, that was not the case with his brand new car and he recovered nothing. The car was a total loss.

Real estate investors recognize the need to insure their real estate investment, or in some cases real estate investments, and undoubtedly have ample insurance coverage in the event something like a fire destroys it.

Nonetheless, insurance can be a very complicated aspect of the rental business to understand, and most people buy the insurance policy without really understanding what in fact they have purchased.

Hopefully, when you set up your policy, you meet with an insurance agent who explained the policies available, and in turn fully understood the policy and your investment property concerns.

But just in case, here are a couple of things about two types of insurance policies you might want to consider.

1. Replacement-cost policy. A replacement-cost policy provides the money it would take to replace the building at current standards in the event that the building is a total loss. If your building costs $300,000 to replace, you are awarded $300,000 to replace it.
2. Cash-value policy. With a cash-value policy, the insurance company sends out an appraiser to determine a value for the building. Regardless of what amount you insure your building for you are paid what the appraisal states that the building is worth—which can be less than what you insured it for, but never more. In other words, under this type of policy, if you insure your building for $300,000 but the appraiser determines a value for the building at $200,000, you get $200,000. On the other hand, if you are insured for $300,000 and appraiser comes in at $350,000, you only get $300,000.

Okay, but what does a real estate broker and real estate investment software developer know about insurance? Only that it is easy to think you are suitably covered by insurance in the event of property loss and horrible to discover later when you are standing knee deep in ashes that you are not.

My expertise is not insurance and my intention is not to give advice about insurance. I simply want to suggest to my real estate investing friends that if you are not 100% positive that if your apartment building burns down that you will receive the money you are expecting, place a call to your insurance agent today and discuss it.

Real estate investing offers enough challenges without having to having to endure watching your real estate investment burnt and your pocket book right along with it.

Cash-on-cash is a rather popular return many real estate investors use for real estate investment analysis because it is easy to compute.

Nonetheless, many investors who forgo real estate investment software and attempt to make the calculation themselves are doing it wrong, and therefore it seems appropriate to discuss it.

What is the Cash on Cash Return?

Cash-on-cash measures the ratio between the cash flow a real estate investment property is anticipated to collect during the first year of operation and the amount of cash investment the real estate investor initially makes to purchase the property.

Often, where many real estate investors go wrong when computing cash on cash is not to correctly compute the amount of initial cash investment made to purchase the property. Namely, down payment, loan points, and cost of acquisition (escrow and title fees, appraisal, and inspection costs).

Instead, real estate investors tend to consider only the down payment as the cash investment and ignore inclusion for loan points and other costs associated with the purchase like escrow and title fees.

Perhaps not a major deal, but anyone seeking to compute cash on cash correctly, and as accurately as most real estate investing software solutions, should make the adjustment.

How to Calculate Cash on Cash

Cash on cash is relatively straightforward. Cash Flow divided by Initial Investment equals Cash on Cash Return.

The result is expressed as a percentage. For example, $5,000 cash flow divided by $100,000 cash investment equals 5.0% Cash on Cash Return (or CoC as most APOD’s and proformas might show it).

Advantages of Using Cash on Cash for Real Estate Investing

1. Cash on cash enables the real estate investor to gauge the profitability of one investment opportunity to another. Regardless whether the investment opportunity is residential or commercial real estate or another-type investment, cash on cash is a suitable way to measure the return on cash invested to the anticipated first year’s cash flow.
2. Cash on cash enables the real estate investor to compare similar real estate investment properties. Again, whether the investor is considering the purchase of residential or commercial real estate, cash on cash helps the investor to measure and compare returns various real estate investment properties might yield.

Summary

Not unlike most returns useful for real estate investing, by itself, cash on cash should not be used to decide whether a property is fit to buy.

Moreover, in as much as it does not account for time value of money, cash on cash is primarily useful to a real estate investor one time during a real estate investing analysis–as a measurement of the first year cash flow, not future year’s cash flows.

Nonetheless, cash on cash is not without benefit, and prudent real estate investors would be wise to compute it when making real estate investing decisions, choose a real estate professional who knows how to compute it, and when deciding to purchase real estate investor software to be sure it is included.