If you’re starting to invest in real estate, you may have heard the terms “cap rate” and “cash-on-cash return.” If you’re like me when I got into investing, you probably have no idea what those terms mean.
Today I want to explain what cap rates and cash-on-cash returns are and why they are important.
Cap Rate
Capitalization Rate, often abbreviated as “Cap Rate” is a metric used to estimate the rate of return on a commercial property. This is based on the income that the property is expected to bring in on a yearly basis and the market value of the property.
To find the cap rate divide the total net revenue that a property is expected to yield in a year by the market value of the property.
In simple terms, the cap rate tells you what percentage of the total price of the property you will earn back in a year.
If you spend $100,000 to purchase a property that is expected to bring in a net revenue of 10,000, the cap rate for that property is 10%.
It is important to note that cap rate does not factor in a mortgage if you’re taking out money to buy the property.
Cap Rate is used primarily when investing in commercial real estate. It’s not something that you usually see on residential properties. However, you may see cap rates if you’re looking at a residential duplex or triplex, but these are the only exceptions.
Usually, when people are talking about residential properties, they will use a metric called cash-on-cash return.
Cash-On-Cash Return
Cash-on-cash return is a rate given as a percentage that tells the amount of cash that will be returned on an investment. To find the cash-on-cash return, divide your annual cash flow before taxes by the total amount invested into the property. (Your cash flow is your gross income after all expenses have been considered.)
In simple terms, this will tell you what percent of your total investment you’re making back in a year.
If you invested $100,000 and you have a cash flow of $15,000, the cash-on-cash return was 15%.
What Are Good Rates?
Because there are so many factors that will affect these rates such as the local market, the economy, and the location of the property, good rates can be hard to pin down.
Generally speaking, a good cap rate would be anywhere around 5-10%. Right now in Fort Worth, it is difficult to find anything in the upper end of that range.
A good cash-on-cash return generally ranges from 7-12%.
The desires and expectations of the investor also may affect what is considered a good rate. There are some investors that would be perfectly happy with a 7% cash-on-cash return. Others would only consider an investment if the cash-on-cash return is at least 15%.
Conclusion
Cap rate and cash-on-cash return can both be very helpful metrics when comparing different investment properties. Whether you’re looking at commercial or residential investments, the most important thing is to find a deal where the numbers make sense.
If you have any questions, want to know more, or would like to buy or sell a property, don’t hesitate to call the number on our website. We would love to help you with all your real estate needs.
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