Cap Rates as well as demand for incomeproducing properties will move up or down depending on market conditions . The term Cap Rate compression reflects a movement of the rate down because investors perceive real estate as a lowerrisk , higher reward asset class relative to other investment options . Cap Rate decompression may result from demand for real estate purchases where Cap Rates increase , reflecting lower valuations . This may be a byproduct of higher interest rates or government intervention such as rent control .
CashonCash Return :
Cashoncash return is a quick analysis to determine the yield of an initial investment . The cashoncash return 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 cashoncash return for this property would be :
$ 100,000 /$ 400,000 = 25 % = cashoncash yield .
If the borrower were to purchase the property for all cash , as contemplated in a Cap Rate calculation , then the cashoncash return would be : $ 100,000 /$ 1,200,000 = 8 % ( this example the 8 % is both the cashoncash yield and Cap Rate ).
It is clear from this formula that leveraging or financing real estate transactions will yield a higher cashoncash return , provided the transaction is financed at a favorable interest rate .
Internal Rate of Return ( IRR ):
Internal rate of return ( IRR ) refers to the yield that is earned or expected to be earned for an investment over the period of ownership . IRR for an investment is the yield rate that equates the present value of the outlay of capital and future dollar benefits to the amount of money invested . IRR applies to all dollar benefits , including the outlay of the initial down payment plus cost , the positive monthly and yearly net cash flow , and positive net proceeds from a sale at the termination of the investment . IRR is 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 investor should determine their risk tolerance to reflect their portfolio ’ s ideal riskreward level . A lower Cap Rate means a higher property value . A lower Cap Rate would imply that the underlying property is more valuable , but it may take longer to recapture the investment . If investing for the longterm , one might select properties with lower Cap Rates . If investing for cash flow , look for a property with a higher Cap Rate . Declining Cap Rates may mean that the market for your property type is heating up , and demand is intensifying . For Cap Rates to remain constant on any investment , the rate of asset appreciation and the increase of NOI it produces will occur in tandem and at the same rate .
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