Calculating Returns in Real Estate Investing

by David | Dec 8, 2014 | Real Estate Basics

Valuating real estate investments can be complicated, but there are a few basic values that are important to understand. The two that we’ll focus on in this post are: capitalization rate and cash on cash return.

Capitalization rate (also known as “CAP rate”) is the ratio between the income of a property and its cost.

Cash on cash (or “COC”) return is the ratio between the amount of cash flow the investor receives and the amount invested.

Let’s look at an example of how to calculate these two valuations. A real estate investor purchases a property valued at $100,000 and uses a conventional 30-year mortgage, allowing her to put down 20% of the value of the house. She pays $20,000, and the rest of the $80,000 is paid with the mortgage. The monthly numbers for this house are:

If we multiply the NOI and cash flow by 12 we’ll see that, over the course of a year, the NOI is $8,760 and the cash flow is $3,528.

In order to calculate the CAP rate, we divide the yearly NOI by the value of the house (as defined above, the ratio between the income of a property and its cost). In this case, NOI ($8,760) divided by the value of the house ($100,000) gives us an 8.7% CAP rate.

To calculate the COC return, we divide the yearly cash flow of $3,528 by the amount the investor spent on the house ($20,000), which gives us a COC of 17.6%. Note that we’ll typically add closing costs to the amount the investor spent and also deduct maintenance and vacancy costs from the cash flow to get a more accurate COC.

So, now what?

When these ratios are useful

Calculating CAP rates and COC returns comes in handy when comparing two properties that have different costs and determining which one is a better investment. It’s really easy to compare two houses in the same neighborhood that cost the same. For example, if houses A and B are both priced at $100,000, and the monthly cash flow for house A is $150 while for house B it’s only $100, we can easily understand that house A makes for a better investment. But, if the houses don’t cost the same, then we need to use CAP and COC to compare them.

Let’s say house A costs $100K and house B costs $70K. If house A produces a monthly cash flow of $150 and house B produces a monthly cash flow of $100, we can use the cash on cash return to better understand which house has the higher return on investment. (We’ll assume that for both, we’re leveraging our money and putting 20% down.)

So, in this example, our investor will receive a higher rate of return with house A.

Calculations are also useful when comparing different investment options, such as investing in a house vs. investing in the stock market. Let’s take another example: Our investor has $25,000 to invest. Her friends tell her that they’ve been getting an average of 8% return on their investments in stocks (in the case of $25,000, that will provide a yearly cash flow of $2,000). Her alternative to investing in stocks is purchasing a house by using the $25K as a 20% down payment and buying a $125,000 house. The house’s monthly cash flow is $200. So:

*Doesn't matter for this example. Leverage is an important topic, but we'll save it for a different post.

So, in this case, we see that investing in the house will provide our investor with a higher return.

Apples to Apples

To conclude, the point of these valuations is to help us compare different investments in order to see which provides the higher return. Of course there are other factors to look at when comparing investments, such as the neighborhoods where the houses are located, appreciation, etc., but these are the basic values you need to know how to calculate.