Cap Rates & Cash on Cash Returns

Cap Rates

The term cap rate is an industry term primarily used in commercial real estate and is short for capitalization rate. The cap rate represents what the return on an investment would be if the investor paid all cash for a property. Cap rates are typically expressed as a percentage and can be calculated by taking the property’s gross revenue, minus the property’s expenses (expenses do not include the debt service), divided by the purchase price. The figure obtained from deducting expenses from gross revenue is referred to as Net Operating Income or NOI. Net Operating Income is a very important term in the industry and one you need to familiarize yourself with if you plan on doing any commercial real estate investing. The following example calculates a cap rate.

Example 1:

Annual Income -	$205,000
Annual Expenses -	90,000
Net Operating Income -	$115,000
Purchase Price -	$1,500,000
Cap Rate -	7.6%

The 7.6% cap rate in the above example equates to what the investor would earn on his investment if he paid the $1,500,000 purchase price in cash. Even though most investors don’t pay cash, cap rates assume you do. The most important calculation (in our opinion) is the cash on cash return which does factor in the debt service. We will talk about this in a moment.

Cap rates are a very effective tool for measuring return on investments across different types of properties in different areas. Because these calculations are based on net income produced versus purchase price, you have a standardized method for determining which investment is best. An important fact is that different kinds of properties (residential, commercial, industrial) will have a different rate, even if they are in the same location. Remember, the capitalization rate is the measure of the profitability of an investment. Different types of properties have different risks and therefore a different expectation of profit for taking on that risk.

An important fact to remember is the higher the risk the higher the reward. If you purchase an apartment complex in a low income neighborhood you would expect a higher return than if you purchased a retail strip center in a good area anchored by national tenants. The cap rate on the apartment complex might be 8.5% while the retail strip center might only be 6.75%.

Where cap rates can be very effective is if you are looking to purchase a property and you are comparing two similar buildings. For example, let’s say you are comparing two apartment complexes both of which are in low income areas. One property has a 7.5% cap and the other an 8.5% cap. If the properties are similar and in the same area then you would more than likely choose the property with the 8.5% cap as you would receive a higher return on your investment.

The cap rate is often used by appraisers in determining a property’s value. This method of appraising is called the income approach. For example, an appraiser may say an office building of a particular type in a particular area should produce a return of 8%. If that building is producing $110,000 in net operating income and the cap rate is 8% we know the building’s value is $1,375,000. As mentioned earlier, an important idea to remember is that cap rates not only vary in different parts of the country, but also in different parts of a city, with different property types and can change between buildings that are within a few blocks of each other.

As investors, it’s important to know the cap rate of a particular property type in a particular area. Most of the time you can discover the cap rate for the type of property in an area by talking to a commercial appraiser or a commercial broker. Once known, it’s easy to determine whether you’re purchasing the property at market value, above market value or below market value.

If for example we are looking to purchase an apartment complex and the cap rate for that particular type of property in that area is 8.5%. We can easily determine if the purchase price of $1,800,000 on a property that has a net operating income of $195,000 is a good deal or not. All we need to do is divide the net operating income into the purchase price to determine the cap rate. If the cap rate is higher than 8.5%, meaning we will be receiving a higher return on our investment, we are interested in buying. If it is lower, we may want to pass. The calculations are as follows.

Example 2:

Cap Rate Determination

Purchase Price	$1,800,000
Net Operating Income (NOI)	195,000
Cap Rate	10.8%

Value Calculation

Property & Area Cap Rate	8.5%
Net Operating Income (NOI)	$195,000
Market Value	2,300,000

In the example the cap rate is calculated and equates to 10.8%. We are now very interested in this property as we would be getting over a 2% higher return than what the market has determined we should get. In other words, if we divide the cap rate into the Net Operating Income we can determine what the property is really worth. In our example, we would be buying a property that is worth $2,300,000 for only $1,800,000, which is obviously a very good deal.

Cash on Cash Return

As we mentioned earlier, cap rates can be a good standardized method for determining your return on investment, but by far the most important factor as investors that we should be concerned with is our cash on cash return.

Simply put, our cash on cash return is the amount of cash (actual dollars) we expect to get back for the amount of cash (actual dollars) we put up. Going back to our first example, let’s say that we are purchasing a property for $1,500,000 that has an NOI of $115,000. We know our cap rate is 7.6% but what is our cash on cash return?

In the commercial real estate industry, banks typically want to see an investor come up with a 20% down payment. Now the down payment can come from the investors pocket, a friend or relative of the investors, a 1031 tax deferred exchange property and any of a number of other ways. What a bank is really saying is they are only going to put up 80% of the purchase price or appraised value and you need to figure out the rest.

For this example, let’s put up the 20% down payment out of our pocket. If we are purchasing the property for $1,500,000 then our down payment is $300,000. Let’s assume for simplicity that we have $25,000 in closing costs. We have now invested a total of $325,000 (actual dollars) out of our pocket. The first part of determining cash on cash return is complete so now let’s figure out the other half of the formula, the money we get back. With a 20% down payment, we are left with a loan balance at $1,200,000 which will give us a monthly payment of approximately $9,000 which equates to an annual debt service of $108,000. A quick an easy way to determine monthly payments, if you don’t have a financial calculator handy, is to take the principal loan balance and multiply it by .0075. This will give you an approximate monthly payment based on a 7.5% interest rate with a 25 year amortization schedule. If you want the annual debt service just multiply the monthly figure by 12.

We now have all the information we need to determine our cash on cash return. We take the NOI and minus the annual debt service to determine our in pocket cash return (actual dollars) and divide that into the amount of actual dollars invested.

Example 3:

Purchase Price	$1,500,000
NOI	$115,000
Out of Pocket Cash	$325,000
Debt Service	$108,000
Loan Amount	$1,200,000
Cash Return	$7,000

Out of Pocket Cash	$325,000
Cash Return	$7,000
Cash on Cash	2%

As you can see, even though we had a decent cap rate at 7.6% our cash on cash return is unacceptable. We would want to walk away from this deal as we could invest our money in the stock market, bonds, CD’s, or savings accounts and do much better.

Leaving everything constant, let’s use our second example above and see what our cash on cash return would be.

Example 4:

Purchase Price	$1,800,000
NOI	$195,000
Out of Pocket Cash	$395,000
Debt Service	$129,600
Loan Amount	$1,440,000
Cash Return	$65,400

Down Payment	$395,000
Out of Pocket Cash	$65,400
Cash on Cash	17%

As you can see 17% cash on cash return is a very decent return. Remember this only calculates cash on cash return and does not factor in an investor’s entire return on investment. If we were to add property appreciation and tax deductible depreciation, the return on investment could exceed 35% with only a 2% increase in appreciation. Now that’s a return to write home to mom about!

Gross Rent Multiplier

The last term you will probably hear when dealing with commercial property is Gross Rent Multiplier or GRM. We are not a big fan of the GRM because it does not take expenses into account. Think of the GRM as a quick and easy way to estimate value similar to the use of the PE, or price earning ratio, in valuing stocks.

The biggest problem with the GRM is that it presupposes there is a number, the GRM, that you can multiply times the gross income of a property to estimate the properties value. Unfortunately, different financial components of a property can throw the gross multiplier off, like the rents are well below market value or the expenses are too high.

GRM is also a little confusing as the ratio is an inverse relationship to price. For example, a GRM of 7 is relatively good. If the number falls below 7 then the property becomes an even better deal. If, however the number climbs above 7, then the property may be too expensive for the return on investment desired. In addition, if you have determined that the GRM is good (meaning below 7) all that means is that you need to do further research. If the GRM is poor (meaning above 7), it may mean you also need to do further research as to why it’s high. A GRM above 7 is not necessarily bad it just means there may be some issues with the property that need to be solved, like high expenses or low rents. These issues can be resolved very quickly and now the GRM would fall well below 7 and you end up with a great deal. As you can see, the GRM does not help to determine anything and in either case, further investigation is needed. Use the GRM as a guideline and you will be fine, but whatever you do, don’t take it as Gospel Truth.