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.
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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.
