Earlier this year, U.S. News & World Report explained why investing in single-family rental property can be a safe haven in a volatile market.
The outlook for the rental property market is strong, the demand for housing is increasing due to low unemployment, and more people are choosing to rent rather than own. While the demand from tenants for single-family rental property is growing, real estate investors should realize that not all rental property is created equal.
Two of the most important metrics used to analyze the financial performance of income property are the cap rate and cash-on-cash formulas.
Cap Rate: What It Is and How To Use It
Real estate investors use the cap rate formula to compare the annual return (or potential returns) to the market value of a rental property:
Cap rate formula
- Capitalization rate = Net operating income / Market value
- $12,000 NOI / $150,000 market value = .08 or 8% cap rate
In this example, a real estate investor can expect to receive an annual return of 8% from a rental property worth $150,000.
By rearranging the cap rate formula, investors can also determine what the NOI and fair market value of a property should be.
Using the cap rate formula to calculate NOI
- Cap rate = NOI / Market value
- NOI = Market value x cap rate
- $150,000 market value x 8% cap rate = $12,000 NOI
Using the cap rate formula to calculate market value
- Cap rate = NOI / Market value
- Market value = NOI / Cap rate
- $12,000 NOI / 8% cap rate = $150,000 market value
What is a good cap rate?
The answer to this question depends on if you’re buying or selling. For sellers, a lower cap rate means the sales price of the property will be higher. For buyers, a higher cap rate could mean a better deal.
The fact is that cap rates vary from market to market. Factors that affect market cap rates include:
- Age of the property
- Neighborhood the property is located in
- Amenities and access to transportation
- Demand for rental property in the market
- Job and population growth in the market
Looking at the Roofstock Marketplace is a way to get a feel for what the market cap rates are in areas you’re thinking about investing in.
There are literally hundreds of properties in different markets across the U.S. You can compare cap rates, rents, total 5-year returns and more for single-family rental properties.
Four important things to remember about the cap rate formula
- Net operating income (NOI) – not gross income – is used to calculate cap rates and is based on an annual amount.
- NOI includes normal operating expenses but not the mortgage payment.
- Cap rate formulas can only be used for income-producing property, or to project how much rental income should be generated from an unoccupied property.
- Cap rate formula is used to evaluate comparable properties in the same market area.
How to use cap rates
Real estate investors use the cap rate formula to measure or forecast how much profit they can expect to receive from different properties, expressed as a percentage. So, the bigger the cap rate percentage the higher the return is.
Another use for cap rates is to measure risk. For example, assume the market cap rate for comparable single-family rental properties is 8%. If an investor sees a house offered at a 10% cap rate, the first question to ask is, “Why is the cap rate 25% higher than other similar single-family homes?”
Now, there might be a good explanation for this. Maybe the seller is motivated and has priced the property low to sell fast. Alternatively, they might be an out-of-state owner who has the rent below market because the owner doesn’t know what the fair market rent should be.
Both of these situations could represent a great opportunity for the savvy buyer. However, there are also not-so-good-reasons -- we’ll call them “red flags” -- that a real estate investor should watch out for.
The house may be priced low because there is a lot of deferred maintenance work that needs to be done. Routine items such as painting, installing new flooring, replacing an outdated HVAC system, or putting on a new roof can easily add up to thousands of dollars. As a result, the net operating income goes down and what appeared to be a good deal quickly becomes a money pit.
This doesn’t necessarily mean that an investor shouldn’t buy the investment property. It does mean that cap rates can be deceiving, so it’s important to ‘look under the hood’ to make sure the numbers add up.
Cash-on-Cash: What It Is and How to Use It
Real estate investors use the cash-on-cash return formula to measure how quickly the amount of cash invested in a property will be returned to them. Cash-on-cash return is expressed as a percentage. The higher the percentage, the quicker the return on investment.
Cash-on-Cash Formula
The cash-on-cash formula compares the net cash generated after paying normal operating expenses – including the mortgage -- to the amount of cash invested in the property:
- Cash-on-cash return = Before tax cash flow (NOI – mortgage payment) / Total cash invested
- ($12,000 NOI - $7,200 mortgage payment) = $4,800 before tax cash flow / $37,500 total cash invested = 12.8% cash-on-cash return
In this example we assumed the investor made a 25% down payment on the $150,000 rental property ($150,000 x .25 = $37,500) and had an annual mortgage payment of $7,200.
The cash-on-cash return formula can also be used to calculate how much cash needs to be invested to achieve a targeted return, and how to obtain a specific before-tax cash flow. However, doing these calculations can be complex because the mortgage payment changes based on the amount of cash down.
How to calculate cash-on-cash return without financing on a real estate investment
Let’s use the example of a 2-bedroom, 1-bath property in Saint Louis. The house is currently rented for $725 per month and has an asking sales price of only $40,000 with a cap rate of 11.96%.
Since there’s no mortgage payment, the NOI is equal to the before tax cash flow. We can use the cap rate formula to calculate the NOI:
- Cap rate = NOI / Market value
- NOI = Market value x cap rate
- $40,000 market value x 11.96% cap rate = $4,784 NOI
Now that we have the NOI we can calculate the cash-on-cash return without financing:
- Cash-on-cash return = Before tax cash flow / Total cash invested
- $4,784 before tax cash flow / $40,000 total cash invested = 11.96%
Note that when an investor pays all cash for a real estate investment, the cash-on-cash return is the same as the cap rate because there’s no mortgage payment.
However, how would the cash-on-cash return change if an investor decided to spend $2,000 repainting the outside of the house during the first year of ownership?
- $2,784 before tax cash flow ($4,784 NOI - $2,000 repainting expense) / $40,000 total cash invested = 6.96%
In the second year the cash-on-cash return would increase back up to 11.96%, assuming there are no changes to the NOI.
What is a good cash-on-cash return?
Just as with our “What is a good cap rate?” question, there’s no right or wrong answer to what makes a good cash-on-cash return. Some single-family investors are happy with an 8% return on their cash invested, while others look for cash-on-cash returns in the double digits.
However, as a single-family rental property investor, it’s important to realize that the amount of leverage on a property has a significant impact on the cash-on-cash return.
In other words, while the cap rate of a specific property is the same for every investor, cash-on-cash return varies from investor to investor.
How leverage affects cash-on-cash return
For example, let’s assume an investor has $20,000 to invest. Using our $40,000 rental property in Saint Louis, we already know that the unleveraged cash-on-cash return is 11.96%.
Now let’s look at how the cash-on-cash return would vary if the investor makes a 50% down payment of $20,000 with a monthly mortgage payment of $100:
- Cash-on-cash return = Before tax cash flow / Total cash invested
- ($4,784 NOI – $1,200 annual mortgage payment) = $3,584 before tax cash flow / $20,000 total cash invested = 17.92% cash-on-cash return
Our investor can also boost or ‘juice’ the cash-on-cash return by putting less money down. By making a 25% down payment of $10,000 and financing the balance with a monthly mortgage payment of $200, the cash-on-cash return would be:
- Cash-on-cash return = Before tax cash flow / Total cash invested
- ($4,784 NOI - $2,400 annual mortgage payment) = $2,384 before tax cash flow / $10,000 total cash invested = 23.84% cash-on-cash return
While the 11.96% cap rate is the same for every buyer, an investor who pays all cash, or puts $10,000 or $20,000 down would have three different cash-on-cash returns of 11.96%, 17.92%, or 23.84%.
Key takeaways for cap rate vs. cash-on-cash return
Cap rate compares the net operating income a rental property generates to the purchase price of the property. It provides an apples-to-apples comparison of similar properties in the same market.
The return (or cap rate) of a specific property is the same for every investor. That’s because the mortgage payment isn’t included in the cap rate calculation.
On the other hand, cash-on-cash measures the potential profit an investor can expect to make on total cash invested. Because cash-on-cash does include the mortgage payment, the same investment property can have different cash-on-cash returns based on different amounts of leverage.
Finally, there’s no right or wrong answer to “What is a good cap rate?” or “What is a good cash-on-cash return?”. The answer really depends on each investor’s unique goals and investment strategy.
Roofstock is a great place to begin analyzing the potential returns from hundreds of single-family rental properties across the U.S. You can review market rents, cap rates, total yields and much more.
