Cap Rate vs. Cash on Cash Return
Capitalization Rate vs. Cash on Cash Return:
Many real estate investors are quite familiar with the cap rate formula but can be somewhat
confused when talk turns to the cash on cash return formula. Tenant In Common investments
typically refer to cash on cash return. This is because many TIC’s are structured to provide cash
flow and wealth preservation for their investors.
The following primer is aimed at allowing investors to clarify how the two formulas relate and are
used. The Capitalization Rate (Cap Rate) formula is used to determine the value of income
producing properties. The Cap Rate utilizes the net operating income (NOI) taking into
consideration the gross rents and other income on the property in addition to all expenses and
vacancies. NOI / Value = Cap Rate.
Other methods such as Gross Rent Multiplier (GRM) use only the gross rent in determining the
value of the property and ignores expenses. The Cap Rate formula allows buyers of properties to
evaluate different properties in the same area using a market cap rate. It is important to note that
the cap rate formula does not take into consideration debt service. This is because a particular
investor may or may not use financing in the purchase of a property.
An example would be that office buildings in a certain area sell in the range of 6 to 7 cap rates but
you are looking at one that works out to be a 2 cap rate. One has to look at why the higher price
and thus the lower return. The Cash on Cash Return formula is used to determine the annual
return on investment (ROI) one would receive on the amount of cash that one would put into a
particular investment. Cash x Annual Rate of Return = Annual Cash ROI. Cash on cash formula
allows one to determine the annual cash return one would receive on a particular investment with
consideration of all income and expenses including but not limited to Debt Service, etc. This is
sometimes referred to as net spendable.
Another measure of return you will see