Although no single return should ever be relied upon to tell the whole story about any income-producing property, nor alone should be used to make any investing decision, it seems appropriate to discuss two of the more popular and commonly used returns—capitalization rate and cash-on-cash—in order to see why they are included in a real estate analysis, and how they generally assist real estate investors during the investing process.

Let’s begin by making a distinction between the two returns.

Capitalization rate (also known as cap rate) is a return that measures the ratio between a property’s net operating income and its sale price (or value). For example, if an apartment building is listed at $600,000 and generates a net operating income of $47,880, we can safely assume that the property is listed at a 7.98% cap rate merely by dividing the net operating income by the sale value.

The cash-on-cash return (or COC as it’s labeled in many real estate analysis reports) measures the ratio between the annual cash flow generated by the property and the cash required to make the investment. For example, if a buyer must invest $94,400 cash to purchase an annual cash flow of $11,934 generated by the apartment building, the investor’s COC would be 12.64% (cash flow/initial cash investment).

Fair enough.

Still, albeit informative to understand the distinction, neither explanation really makes it clear which rate of return might catch the investor’s eye and arouse enough additional interest to pursue a purchase. So let’s consider what each return is really telling us about the investment opportunity.

Cap rates are mostly used to determine whether or not a property’s value is in-line with other similar rental properties in the general market area. For example, given that the apartment building illustrated above is selling at a 7.98% cap rate, we can determine whether it is listed at a fair market value by comparing it to the capitalization rates other similar rental properties recently sold for in the area. To do this we would simply divide each sold property’s net operating income by its sale price. If we conclude that each comparable averaged (say) 7%, then it would appear the property is priced fairly, whereas a comparable average of (say) 9% could be an indication that it is over-priced. There are many factors to consider, of course, but you get the idea.

Cash-on-cash concerns the return the investor might expect to earn on the initial investment he or she is required to make for the purchase. This is about the investor’s cash outlay and the property’s cash flow, and is irrespective of value. In other words, with extremely favorable financing and low down payment, it is conceivable that the investor might get a reasonable return on even a modest cash flow despite paying more than fair market value. Likewise, unfavorable financing and a large down payment could adversely affect the return despite paying less than fair market value.

Since it is rare for anyone to want to pay more than fair market value, I typically made investing presentations to my customers that began with an emphasis on capitalization rate; this at least gave notice to the investor that the price was in the ball park. On the other hand, I know of agents that tend to focus on cash-on-cash return; maybe as a way to compare a particular real estate investment to some other type of investment. In a perfect world, of course, both would be desirable for an investment decision, but that seldom occurs, and we have to start somewhere.