Cash on Cash Return
Cash on cash return is a quick analysis that can be done to determine the yield on an initial investment . It is developed by dividing the total cash invested ( the down payment plus initial cost ), or the net equity into the annual pretax net cash flow .
Assume the borrower purchased the property which costs $ 1,200,000 and provides an NOI of $ 100,000 , with a $ 400,000 down payment representing the equity investment in the project . The cash on cash return for this property would be :
$ 100,000 / $ 400,000 = 25 %
If the borrower were to purchase the property for all cash , his cash on cash return would be :
$ 100,000 / $ 1,200,000 = 8 %
It is clear from this formula that leveraging or financing real estate transactions will yield a higher cash on cash return , provided the transaction is financed at a favorable interest rate .
Internal Rate of Return
The internal rate of return (“ IRR ”) refers to the yield that is earned or expected to be earned for a given capital investment over the period of ownership . The IRR for an investment is the yield rate that equates the present value of the future benefits of the investment to the amount of capital invested . The IRR applies to all expected benefits , including monthly and yearly cash flow and the proceeds from resale at the termination of the investment . It can be used to measure the return on any capital investment , before or after income taxes . Ideally , the IRR should exceed the cost of capital .
Is there an ideal Cap Rate ?
Each growth investor should determine their own risk tolerance that will reflect the ideal for their portfolio . A lower Cap Rate means a higher property value . A lower Cap Rate would mean that the underlying property is more valuable but that it may take longer to recapture the investment . Whichever Cap Rate is targeted will represent the annual return overtime ( before financing costs and taxes ) an investor can expect to make on the investment at the time the property is acquired . If investing for the long term one might select properties with lower Cap Rates . If investing for cash flow , look for a property with a higher Cap Rate . It ’ s valuable to look at historical Cap Rates and Cap Rate trends on the specific property type in a specific geographical location .
Declining Cap Rates may mean that the market for your property type is heating up . A Cap Rate that is either at the top of the range or at the lower end of the range is likely to change , and it may be wise to adjust the analysis and / or investment strategy accordingly . And make certain , when comparing Cap Rates , to compare the same geographical locations and property types , apartments to apartments . For Cap Rates to remain constant on any given investment , the rate of asset appreciation and the increase of NOI it produces will occur in tandem and at the same rate .
Below are examples of the effect changes in NOI and / or Cap Rates on asset values :
As NOI increases and Cap Rates remain the same , asset value increases .
NOI CAP RATE ASSET VALUE $ 300,000 / . 06 = $ 5,000,000 $ 350,000 / . 06 = $ 5,833,000 $ 400,000 / . 06 = $ 6,666,666 $ 450,000 / . 06 = $ 7,500,000
The effect on Asset Value when the Cap Rate varies .
NOI CAP RATE ASSET VALUE $ 500,000 / . 03 = $ 10,000,000 $ 500,000 / . 04 = $ 8,333,333 $ 500,000 / . 05 = $ 7,142,857 $ 500,000 / . 06 = $ 6,250,000
Cap rates are driven by property type , geographic location and market sentiment . During the recent recession , as property values fell , Cap Rates increased dramatically for some property types in certain areas of the country . The improving economy has reversed that trend .
92