We've all heard it before: "Cash on Cash" is the holy grail of investing success, and the more you have, the better off you are. More money means more opportunities, right? Well, let's start by debunking this myth. Cash on cash is a metric that helps investors compare their returns to those of similar companies operating in similar industries.
The metric divides net income into current assets and then assumes 100% equity ownership (which assumes no borrowings) to calculate its value. To determine a company's cap rate — which is simply a company's investment return as a percentage of its asset value — we can use the cap rate formula that takes into account debt levels and total liabilities. The formula for calculating cap rate is:
Cap Rate = Net Operating Income / Total Asset Value
"But wait a minute," you ask. "If cash on cash is equal to net operating income (NOI) divided by total equity investment, then how can it be equal to the company's total asset value?" The answer is because although NOI and cap rate are similar, they are not exactly the same. In fact, NOI tells you how much income a company makes on its assets, whereas cap rates tell you how much money you can make on your investments.
To illustrate this difference let's consider the case of two investors who purchase a property with identical properties and risk profiles. Both decide to purchase a property for $1 million and both know that the NOI is going to be $200,000, so they each choose to put in $500,000 of their own money. The first investor puts in cash while the second chooses to finance. With a 10% down payment he finances $450,000 at 8% interest.
After one year both investors sell their property for $1 million and have after-tax proceeds of $655,000 ( This is what I get if I don't take into account capital gains taxes). Now, let's compare the gross returns. Investor #1 received a 25.0% cap rate on his investment, while Investor #2 received a 10.0% cap rate. If you compare the cap rates for your two investments, you might be surprised to learn that although the return numbers look identical on paper (they both hit their targets), they're very different in reality.
If you know anything at all about property management, this should come as no surprise. What we're seeing here is that real people have a hard time making money with real money and the best way to do that is to diversify.
Now that we've seen how two $1 million properties can produce two different returns, let's see what happens when they are compared to a single property that has the same total return. In this case, Investor #1 and Investor #2 bought a single piece of property for $2 million. Its cap rate is 25%, just like the first pair of investments. If one investor were to sell his share, he would realize a $500,000 return on his investment; however, if the other investor were to sell his share after one year's time he would realize a $400,000 return on his investment. In this example, it was assumed that both investors had invested their full equity (100%) into the deal.
The conclusion from this example is that although NOI is a good indicator of what an investment property will do for you, it is not a good indicator of what it will do when the investor has invested 100% in the deal. In fact, you could say NOI is only as good as the equity percentage that you put into the deal. This means that if you help manage an investment property and have to borrow money to complete your purchase, then the cap rate will be misleading because it assumes 100% equity ownership. If the investor puts in only 80% equity, then his cap rate should be lower than if he put in 100%.
Now that we've seen why cap rates are not the same as cash on cash returns, we can start to understand why it's a foolish measure for real estate investors to use. It's important to realize that the cap rate and cap rate formula is only effective if you are going to put in 100% of the equity for a deal. When it comes to the purchase of an investment property, this usually requires little or no cash. However, when you're investing in real estate as an investor, your goal is typically to use other people's money when possible and not your own. Let's look at two investors who have each purchased a $1 million property with a 75% down payment.
The first investor has a 10% cap rate but the second has a 25% cap rate. If we assume NOI of $200,000 over the same 12-month period as our previous example, then the first investor will earn $100,000 while both investors will receive $50,000 after taxes. However, both investors will receive additional income from just having their property sit there and collect rents. Let's assume that each of them collects $10,000 per month in cash flow over that time period. These amounts are actual averages in many parts of the country and are meant to be used for illustrative purposes only.
So now, among both of our investors, we have collected $60,000 in cash flow. Let's add that to the after-tax proceeds from the previous sale of $50,000. This brings our total to $110,000. Now let's look at how long it will take each investor to recover his initial equity investment (75%). Investor #1 will receive $275,000 for his property since he only put in a 10% down payment ($75,000). He will have received an additional $65,000 in cash flow after he sells the property and has paid off any debt.
He will have recovered his initial investment in 2.1 years. Meanwhile, Investor #2 will have only received $225,000 for his property because he put in $100,000 ($25,000 less than Investor #1). However, he also collected an additional $60,000 in cash flow during this time period. This brings the investor's total to $195,000 and it was all mostly from cash flow. The investor has recovered his initial investment of $100,000 within 1.8 years and has garnered another $95,000 of income from just waiting passively for a year and collecting rents.
The results from this example are clear and investors should be aware of these outcomes when using cap rates as an investment tool. Real estate is a long-term business and investors have to compromise on their returns in order to achieve the overall goal of making money with their investments. If you've decided that your investment is to be a long-term play, then you probably understand that you can't focus exclusively on equity returns or cap rate and should instead focus on collecting income from your property over time.
Cash Flow vs. Income Returns
If you've been in the real estate business for any length of time, you've likely heard real estate financial experts talk about cash flow and income returns. There are many ways to measure income returns and the most commonly discussed has to do with the net operating income (NOI) of an investment property. As shown above, NOI is affected by two primary factors: capitalization rate and occupancy rate.
Capitalization rate refers to the share of gross rents paid from tenants that are being used to pay down debt on a property over time (e.g., principal, interest payments, taxes, insurance). When investment properties are purchased, they typically have high debt levels and these debt payments will be paid by the investor's cash flow. The capitalization rate is also known as a property's debt service coverage ratio or a leverage ratio.
Occupancy rate refers to the percentage of time that a particular investment property is occupied by paying tenants. Occupancy rate is measured by the occupancy period, which refers to how long an investment property is rented out for on a yearly basis over a set period of time (e.g., one year). In most cases, investments are held for more than one year and therefore occupancy rates will usually exceed 100%. This simply means that an investment property was rented out for more than 100% of the time during our period of analysis. The formula for NOI is shown here:
NOI = Gross Rents – Mortgage Payments (Principal+Interest) – Operating Expenses – Taxes
It's important to remember that NOI is not cash flow. The reason for this is because cap rate and occupancy rate are not represented in the calculation of NOI, even though these two factors will directly impact the cash flow received by an investor from a particular property. For example, let's assume that an investor purchased a $300,000 investment property with an 80% down payment ($240,000). He financed $240,000 at 5% fixed interest. The property has an 8% cap rate and a 90% occupancy rate over the first year. His NOI is as follows:
NOI = ($300,000 – $24,000 – $18,600 – $18,600) = $35,400
His NOI is now being used as a way to describe his cash flow because it takes into account both the cap rate and occupancy period for his investment property. ANNOI will be much lower if either of these rates is lowered or if the occupancy period decreases.
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