Cap Rate VS Cash on Cash Return
Cap Rate VS Cash on Cash Return
If you're a beginner a real estate investor or just thinking about beginning to invest in real estate I want to talk to you about some terms that you probably hear thrown around quite frequently which are cap rates and cash on cash returns. I'm going to start with cap rates because it's a little bit easier to understand I think and a little easier to calculate although you know both terms have a sort of a separate purpose and they're both beneficial to use and look at um so let's start with cap rates.
Cap rate ignores the mortgage okay if there's a mortgage on the property it kind of ignores it and it just looks at what is the current value of the property and then divides that by what the net income of the property is so all the rents minus vacancy and minus maintenance minus management you know all the things you spent money on the property how much net income was leftover at the end.
So here's a simple example for you if you had a $100,000 property after paying all the expenses property taxes and management and all that stuff you're left with an $8,000 profit that would be a cap rate of 8 percent which of course would be amazing most rental properties right now we're seeing cap rates closer to six percent all right, it depends on the market but here in the Phoenix area, most investors are pretty happy to get a six percent on their cap rate.
Now, the downside to cap rate is it doesn't really factor in your mortgage you know if you have a mortgage on the property it doesn't really help you understand how much money you're making.
A cap rate is beneficial to help you analyze how one investment performs against another investment but it doesn't really help you understand what your actual return on your money is going to be and that's why I also like looking at cash on cash returns because I feel like this factors in a little bit better if you're going to be using a mortgage and it helps you understand like I mean if you're investing money in the stock market right if you put a hundred thousand dollars into the stock market and a year later your money between your dividends and what is currently in the account is now $110,000 well you know you got a 10% return and that's usually how we think about our money is what kind of return are we getting on our money and that's why I like the cash on cash return let's just use our simple example again of saying that we bought a $100 000 house and we put 20 percent down on it so we have $20,000 into the property you can add in closing costs and some other things like that but i'm just going to use that 20 000 to make the math simple for now.
So you put $20 000 into it then how much money did you make on that 20 000 a year later so let's say a year later the value of the property is now a hundred and ten thousand dollars so your twenty thousand dollars that you initially put in is now has now gone up you have an additional ten thousand inequity so you already have a fifty percent return you could sell the property, get your 20 000 back plus get your 10 000 in increased value so your 20 000 turned into 30 000 right that'd be a 50 return but you also have to add in any cash flow that you got from the rent so let's just say that your leftover cash flow on the rent was $500 a month that'd be pretty good of course but I'm just you know trying to use nice round easy numbers here so $500 a month and you had it rented out all year that's an extra six thousand dollars in cash flow for the year. So you made ten thousand dollars in equity and you made six thousand dollars in cash flow so your twenty thousand created thirty-six thousand because your twenty thousand still there hasn't disappeared it's still in the equity right so you still have that and it gained sixteen thousand dollars so I can't do that math in my head but your cash on cash return almost doubled your $20,000 turned into $36,000.
So whatever that is a 75 return that's what the number I really prefer to look at because it really looks at what you bought the property for instead of the current value is interesting to know and the cap rate is helpful so you can compare investments versus other investments to determine which one is the best but really what I want to know is how good is my money doing for me right? I can put my money in the $500 and I know that in the long run, I'm going to get a 10% return how is my real estate performing versus that because if I'm not getting 10 returns then I might as well invest in the s p now obviously over the past two years the real estate market has been absolutely on fire but I can tell you that between the cash flow and equity gains most of our properties are seeing around a 100 percent cash on cash return each year.
So anytime I buy an investment property and I put $50,000 into it within a year between my cash flow and my equity I'm getting another $50,000 in wealth back so that's why I love rental properties is actually crushing uh what the average stock market returns are doing so I hope you found this a little help if you have a rental or you're thinking about getting a rental and you want me to help you understand what your cap rates or what your cash on cash returns might be I would love to sit down with you. I've got a spreadsheet for all this on my rentals and we can share notes and see how you're doing on your properties. I look forward to talking to you soon..