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As you go through these numbers, don’t forget to refer to the assumptions listed in the document (for things like mortgage payment calculations, etc.) and also don’t forget that when we’re dealing with %s, they will initially show up as decimal points. So if you get a number that comes out to be 0.0345, you want to multiply that decimal number by 100 to get the %. So 0.0345 x 100 = 3.45%. The calculations below don’t include that part, but as soon as you see a decimal number, be sure to multiply that by 100 to see the % number.

Sidenote: Cap Rates are intended to be used on commercial properties rather than residential properties. However, they can still be used on residential properties. With commercial properties, Cap Rates are used to determine the value of the property, which is based on the income the property generates. With residential properties, Cap Rates can’t dictate the value of the property—the market does that. But what a Cap Rate can do on a residential property is give you an idea of the “value” you’re getting in relation to the price and the income it generates. So the true intention of a Cap Rate is to dictate the value (a.k.a. price) of an investment property, but that can only happen on commercial properties. With a residential property, the Cap Rate can only give you an idea of the value of the income vs. price ratio; it can’t dictate the price of the property.

Property #1:

Using a mortgage calculator and the terms listed with the problem, the monthly mortgage payment comes out to be: $678.54

Adding that mortgage payment to the total expenses already calculated—because the Cash-on-Cash Return includes the mortgage—the total expenses become: $614+$678.54= $1,292.54

The net income then—(income – expenses (w/ mortgage)—is = $132.46

Now multiply that net income by 12 to find out the annual net income, which ends up being $1,589.52.

Now you can calculate the Cash-on-Cash Return:

Cash-on-Cash Return:

(annual net income / amount invested) = $1,589.52/$31,600 = 5.3%

  • Remember that the Cash-on-Cash Return uses the amount of cash you invested, so in this case it’s $31,600 because that was your 20% down payment for the mortgage.
  • 5.3% is a pretty low Cash-on-Cash Return. One factor in why the returns on this property are lower than a lot is because of how nice the property is. Typically there is a trade-off in returns with nicer properties—the returns are likely going to be lower because of the decreased risks. The riskier the property, the higher the returns are projected to be (usually). That is to make up for the higher risks. So anytime you’re calculating returns, look at what you’re getting for those returns in terms of the quality of the property and overall potential for the investment.
  • If I were looking at this property personally, I would decide that it is likely a great property to invest in, but only if I’m paying cash for it. With leveraging, the numbers are pretty low. So I would likely end up passing on this property, assuming I’m financing. But I think it would be an amazing property for a cash investor.

Property #2:

Since I’m going to need both the Cap Rate and the Cash-on-Cash Returns for this property, that means I need to know the Cash Flows both with and without the mortgage payment included. I also need to determine the Vacancy and Repair expenses since those were only listed as a %.

Vacancy: 7% of rent = 7% x $2,100 = $147

Repairs: 5% of rent = 5% x $2,100 = $105

Adding these two expenses to the other expenses listed, not including the mortgage = $601 in monthly expenses.

Cash Flow—without the mortgage payment: $2,100 (income) – $601 (expenses) = $1,499

Using a mortgage calculator and the terms listed with the problem, the monthly mortgage payment comes out to be: $1,116.59

Adding the mortgage expense to the total expenses: = $601 + $1,116.59 = $1,717.59 in monthly expenses.

Cash Flow—with the mortgage payment: $2,100 (income) – $1,717.59 (expenses) = $382.41

To calculate the Cap Rate, no mortgage numbers are included.

Cap Rate = (net annual income) / purchase price = ($1,499 x 12) / $260,000 = $17,988 / $260,000 = 6.9%

To calculate the Cash-on-Cash Return, the mortgage numbers are included and instead of the purchase price, we use the amount of cash invested, which in this case is $52,000 because that was the 20% down payment.

Cash-on-Cash Return = (net annual income after mortgage) / amount invested = ($382.41 x 12) / $52,000 = $4,588.92 / $52,000 = 8.8%

  • All of the numbers are decently in the positive. The Cap Rate is strong. The Cash-on-Cash isn’t the highest possible, but it’s not too low either. What I would do if I were looking at this property as a possible investment would be to run the Cash-on-Cash Returns with a few different options for how much I used for a down payment. I’d be curious in what direction that Cash-on-Cash Return would move if I were to put more money down and use less leveraging. Typically the Cash-on-Cashes get higher with more leveraging, but that’s not always the case and with it being on the lower side, I’d be curious how it would change.
  • The numbers seem solid overall. I’d just want to ensure what kind of property I was getting—is it higher-end or lower-end, does it need any work, and how many risk factors are there? If it’s a higher-end low-risk property, these numbers are great and I’d feel good with them. But the numbers aren’t high enough for me to consider a lower-end high-risk property. I would need higher returns to justify the added risk I was taking on.

Property #3:

Since I’m going to need both the Cap Rate and the Cash-on-Cash Returns for this property, that means I need to know the Cash Flows both with and without the mortgage payment included. I also need to determine the Vacancy, Repair, and Property Management expenses since those were only listed as a %.

Vacancy: 7% of rent = 7% x $2,300 = $161

Repairs: 5% of rent = 5% x $2,300 = $115

Property management: 10% of rent = 10% x $2,300

Adding these three expenses to the other expenses listed, not including the mortgage = $971 in monthly expenses.

Cash Flow—without the mortgage payment: $2,100 (income) – $971 (expenses) = $925.74

Using a mortgage calculator and the terms listed with the problem, and remembering that the mortgage is only based on the purchase price and not the rehab costs (remember those are being paid with cash, per the assumptions), the monthly mortgage payment comes out to be: $1,374.26

Adding the mortgage expense to the total expenses: = $971 + $1,374.26 = $2,345.26 in monthly expenses.

Cash Flow—with the mortgage payment: $2,300 (income) – $2,345.26 (expenses) = $-45.26

In addition, this property has a $73,000 rehab involved. The rehab costs weren’t included in the mortgage calculation, but because they are ultimately part of the ‘purchase price’, they are used in the Cap Rate calculation. So that brings the total purchase price to be $320,000 + $73,000 = $393,000.

To calculate the Cap Rate, no mortgage numbers are included.

Cap Rate = (net annual income) / purchase price = ($925.74 x 12) / $393,000 = $11,108.88 / $393,000 = 2.8%

To calculate the Cash-on-Cash Return, the mortgage numbers are included and instead of the purchase price, we use the amount of cash invested, which in this case is $137,000 because that was the 20% down payment ($64,000) PLUS the $73,000 rehab costs (total cash invested).

Cash-on-Cash Return = (net annual income after mortgage) / amount invested = ($-45.26 x 12) / $137,000 = $-543.12 / $137,000 = -0.39%

  • A negative Cash-on-Cash Return means you are losing money. You are making a negative return on the money you’ve invested.
  • In this case, the Cap Rate is positive and the Cash-on-Cash Return is negative. This means that if you pay cash for the property, technically you are in the positive. But if you finance, you dip into negative returns.
  • As with the previous example, you can try various down payments and see at what point the Cash-on-Cash Return become positive.
  • NOTE: The Cap Rate and the Cash-on-Cash Returns are the same number if the property is paid for in cash (because then the amount of money invested is the same as the purchase price).
  • With the Cap Rate being only 2.8%, there’s really no room for error. And since 2.8% is the highest the Cash-on-Cash could be, if you paid cash for the property which is the best you can do, you’re really not getting any kind of deal. If you have one thing go sideways with the property, you’re going to be into the negatives almost immediately. No matter how nice the property, you always want to consider margins for error or freak issues.
  • This is all also assuming the rehab costs exactly what it’s estimated. It’s very often, possibly more than not, that rehab expenses can cost more than initially anticipated. So again, with such little margins, there’s really no room for anything to go wrong.

So which of these properties would you invest in?

If it were me, I would buy property #1 if I were planning to pay cash. If I were financing, I would want to buy property #2 assuming I verify it’s in good shape, no known repairs needed, and it’s a nice property in a low-risk area.

None of these properties really illustrated how advantageous leveraging can be (we picked them at random). When you get a really solid rental property potential, speaking mostly to the numbers, it’s most likely that the Cash-on-Cash Return will be notably higher than the Cap Rate. Oftentimes it can be easily double. The highest one we saw here was 8.8%, which is really on the lower end of what I would look for in a Cash-on-Cash.

As mentioned, if you got tripped up on any of the numbers, reach out! That’s what we’re here for.

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