What is Cash on Cash Return

Understanding how cash on cash return works for real estate is vital when evaluating real estate investment transactions. Before plunging directly into specific examples of cash on cash return scenarios, it’s important to have a firm grasp of what the term exactly means. Starting with a basic formula we can start to see how this calculation is made:

cash on cash return = annual before tax cash flow ÷ total cash invested

As shown in the formula above, cash on cash return is a basic measurement of investment performance which is calculated by taking the cash flow of the property before taxes and dividing it by the initial equity investment. The before tax cash flow figure for each year is based upon the “real estate proforma” and the initial investment of equity is the total purchase price minus any loan proceeds.

Example of cash on cash return

Now for a simple and basic example of how this works. Let’s suppose that you are appraising a duplex that has a projected year 1 before tax cash flow of $20,000. Let’s also conclude that the settled upon purchase price of the property is $400,000 and you can secure a loan for $300,000 which is 75% loan to value. What would be the cash on cash return for one year?

$20,000 ÷ $100,000 = 0.20 = 20%

Now, this calculation is rather simple, your cash on cash return for one year comes down to the one year before tax cash flow divided by your total out of pocket cost. This equates to precisely 20%. This calculation is very basic but allows the investor to understand that their one year return on investment is 20%. Of course all of this is based strictly upon the proper calculations of cash flow projection and the accuracy of your intial equity investment figure.

The cash on cash return calculation is a simple way of measuring investment performance and can be a great way to quickly filter through several different potential investment property opportunities. It is however a very limited form of calculating finite details of investment and predicting future growth or decline.

Discounted Cash Flow Analysis

The simple measurement of cash on cash return to gauge investment performance works as a reasonable good starting point in a proerty evaluation, however when your interest in the property begins to get more serious, it would be wise to conduct a further and more detailed analysis.

A discounter cash flow analysis factors in important elements such as time value of money to place a value on a real estate asset. When considering a time period that extends out over several years, a discounted cash flow analysis estimates future potential cash flows and will discount cash flows back to the present. Utilizing the DCF requires forecasting future cash flows and concluding the necessary total return. After forecasting future cash flows (both incoming and outgoing) you then discount the projected cash flows back to the present-time at the necessary rate of return.

How to Calculate Your House’s Capitalization Rate

The capitalization rate or “cap rate” is a concept that is fundamental to the real estate industry. It is however commonly misused or misunderstood. This post should help clear the term up a bit and allow you to understand how to properly use it.

Definition of Cap Rate

The capitalization rate is the ratio between NOI (Net operating income) to property asset value. An example of this would be if a property was listed on the market for $2,000,000 and generated a NOI of $200,000, this would mean that the capitalization rate would be $100k/$1million, or 10%.

Cap Rate = annual net operating income / cost or (value of the property)

Example of Cap Rate

Let’s suppose that we were researching the sale of a commercial strip center with a net operating income of $450,000 and a sale price of $5,000,000. In the commercial real estate business it would be common to say that the property is being sold at a 9% cap rate.

Logic behind the Cap Rate

The logic and intuition behind using this ratio is to be able to find a percentage return to the investor on a all cash purchase. So, on the example above the investment in that particular property would yield a 9% annual return to the investor.

When to use Cap Rate and when not to use it

The cap rate is a highly common and useful ratio in the commercial real estate sector, and is very helpful various situations. It is very useful when making a quick decision on whether a property investment represents a better value or lower risk when comparing it to other on the market. For example, a 7% cap rate acquisition compared to a 10% cap rate for a similar property in a comparable area should immediately help the investor indicate which property has a higher risk premium over the other.

Another useful way cap rates can come into play is when they form trends. If you look at cap rate trends in a particular market then it can give an investor an indication as to where the market is headed and if it’s an opportune time to invest. Depending on whether the cap rate percentages are rising or falling in a uniform manner that can be shown by the trend, one can make certain assumptions as to the direction of valuations.

Cap rates can be incredibly useful for quick calculations and value comparisons, but there are certain times where they should not be used. For example, if a property’s NOI is unstable of irregularly complex, with large fluctuations in cash flow, a more in-depth discounted cash flow analysis will serve to better reveal a proper valuation.

Essence of the Cap Rate

One way to conceptualize the essence of cap rate is to think about the risk free rate of return that one might get from ironclad or very secure investments like treasury bonds, and subtract that rate from the cap rate to calculate a risk premium. For example, let’s suppose a treasury bond yields a risk free premium of 3% annually. Then let’s say the acquisition cap rate of a certain property is 6%. This would yield a risk premium on the property of 3%, which reflects the entirety of risk the investor would assume over and above the risk free treasury bonds. This calculation does not take into account many important factors such as the age and integrity of the property, the reliability of the tenants, length of current leases of tenants, or any underlining economic factors of growth or recession.

After considering the aforementioned factors on a certain property, it’s then quite easy to see the relationship between risk free rate of return and the overall cap rate. The ultimate risk factor of the property, which is a somewhat subjective combination of the risk premium plus any knowledge gained about the current property functionality will determine if the investment is worth making. In other words, cap rate is a useful formula in helping the investor narrow down risk factors, but the ultimate decision lies with the judgement and experience of the investor and how much risk they deem is worth the return.

The Impact of The Federal Reserve Interest Hike on the US Real Estate Sector

The plunge in dollar prices implies that most real estate firms will be forced to financial borrowing so as to keep level with the expected financial turmoil. The federal government has already signaled a rise in the overall interest rate charged by financial institutions and this is expected to greatly impact on the real estate firms who had already conducted home sales. The biting financial conditions will enable homeowners to typically take longer in order to pay the dues owed to the developers. The real estate firms in return will be somehow hand tied as they will be forced to make a balance so as not to fall into economic disarray. For the potential homeowners who would like to purchase new homes, the hike in interest rates will prompt the developers will lease few of their properties fearing that the prospective buyers will take considerably longer time to successfully complete their payments.

The housing demands in the United States have always been on the upward and this can be explained by the recent economic recovery which has resulted to a growing middle class. This may take another turn as top global economy lie China has been in for a shock as its growth projection for this year has been the lowest as compared to the last 25 years. The Chinese economic shortfall has a direct impact on the dollar prices and the raised interest rates will limit the ability of real estate firms to further expand through creation of new projects. To firms who have had a high debt level, this is a bad news as prospective home buyers are likely not to spend their cash fearing unpredictable economic turmoil as it was with the 2008 recession. As a result real estate developers will try to come to terms with the fact that home sales are expected to be in their lowest as compared to the previous years.

The stakeholders in real estate will be looking forward to seeing any economic move which would see the United States economy gaining some strength. The falling prices for commodities like oil may signal this kind of hope however only slight economic improvements can get to felt. This is due to the fact that the crops export markets is struggling with the dropping prices and this is for the third year running. A hike in the interest rate will force farmers into borrowing from their respective manufacturers. The weak oil and commodity prices will therefore throw the United States economy into a “mini-recession” economic model and this will limit the consumers’ spending. This will directly affect the real estate sector in that home sales are likely to see a considerable drop in sales.

By raising the interest rates the Federal Reserves is likely to spur some kind of inflation and as a result many firms including the real estate developers will be forced to find shelter in some cost-cutting effective measures. Cost cutting measures will imply that the affected firms will be forced into a period of low productivity and for real estate firms this implies reduced home sales as there will be less capital for creating more homes. Real estate firms heavily do rely on financial borrowing so as to keep their projects on toe. Due to the short term hike in the interest rates many of these firms will refrain from conducting more projects for being in fear that their expected profit margins will be reduced as most of the consumers will be greatly handicapped in their spending.

By raising the interest rates the Federal Reserves is likely to spur some kind of inflation and as a result many firms including the real estate developers will be forced to find shelter in some cost-cutting effective measures.

The interest hike shouldn’t be given a negative look as there are some other benefits which will positively impact on both the consumers and manufacturers. Economic analysts base their argument on the fact the United States economy is very strong and the short term hike is expected not to have any considerable effect on home sales by real estate firms. Some potential home buyers are likely not to notice this short term economic plunge that has hit the real estate firms as compared to the economic slump of 2008. Keen buyers will definitely feel the small rise in home prices but this won’t hold many of them back from purchasing their preferred homes. The Federal Reserve hopes that after this time duration that the economy will pick on an even stronger and this will mean a better business environment for the investors which real estate firms being a inclusion.