Capitalization rate is a valuation measure that can be used to compares different real estate investments. Capitalization rate is also referred to as cap rate. Ideally, cap rates are calculated as a ratio between the operating income and the capital cost.
Cap rate = annual net operating income/cost of the asset
Cash-On Cash Return
On the other hand, cash on cash return refers to the equity dividend rate. It is one of the most common formats used in the real estate industry to evaluate income generation of an asset. It can be computed by dividing cash flow before tax by the amount of equity that was initially invested.
Interpreting Cap Rate
Cap rate is therefore an indirect measure of how fast a given asset will pay for itself. If the cap rate is 10%, it means that it will take 10 years before a given asset pays for itself. Similarly, if the cap rate is 5 % it means it will take 5/100 i.e. 20 years before the asset pays for itself.
When it comes to real estate appraisal, the net operating income must be used. In this case, the cash flow will be computed by subtracting the debt service from the net operating income. In a case where the details available is obscure, capitalization rate may be estimated from the net operating income so as to determine the cost or the value required for annual income. Any prudent investor will view his money as a capital asset. Because of this, he expects his money to generate more money as time goes by. Considering such risks and the readily available interest rate will guide him to estimate the personal rate of return. Ideally, this is his cap rate.
Cap rate figures are important since they provide a tool which investors use to value property based on the net operating Income. If a property carries a higher cap rate, it shows that the risk associated with that investment is less. If the cap rate is comparatively lower, it indicates that more of a risk is involved.
Factors That Can Be Used To Indicate More Risk
• Creditworthiness of the tenant
• Location of the property
• General volatility of the market
Computing Cash on Cash Return
Cash on cash return = annual cash flow before tax / total cash invested
This rate can be used in evaluating the cash flow from the income producing asset. When the computation is done, the figure that is arrived at is then used to determine if the property is underpriced or overpriced. Other investors may use it to determine properties that have enormous cash flows.
Limitations of Cash on Cash Return
• The calculation is based on before tax cash flow in relation to the amount invested. It cannot take into account the individuals’ tax situation especially that which can influence the desirability of the investment.
• The formula does not factor in the effects of appreciation and depreciation.
• It does not factor in the risks associated with the underlying property.
• It is a simple interest calculation that ignores the effect of compounding interest. This allows an investment with a lower nominal rate of compound interest to look superior.