InvestorLoft Real Estate Investing Blog

Real estate investment terms - today's topic

Cash flow…cap rate…cash on cash return…

It’s enough to blow your mind, isn’t it?

We’ve put together this primer for our readers from the most common questions our Customer Service Team comes across. They work with our Investor members to define key real estate terms, help them navigate our site and find articles in our Real Estate Investing Articles library day in, day out. So today, we’re focusing on three key terms that real estate investors need to know: Cash Flow, Cap Rate and Cash on Cash Return.

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CASH FLOW

Annual Net Operating Income is also commonly referred to as Cash Flow. This represents the annual income or loss the investment property actually generates after collecting a year’s worth of rent and paying the annual expenses associated with owning and operating the property. Cash Flow is calculated by subtracting the Annual Total Operating Expenses from the Annual Gross Rental Income.

So, the formula is:

Annual Net Operating Income = Annual Gross Rental Income – Annual Total Operating Expenses

Read InvestorLoft’s expanded explanation of Cash Flow.

CAP RATE

Cap Rate is a component of return on investment for an investment property as it relates to the Purchase Price and based on the amount of Annual Net Operating Income the property will yield (not including mortgage payments or considering income tax) in proportion to the purchase price of the property.

Cap Rate is calculated by taking the Annual Net Operating Income (or Cash Flow) of the investment property and dividing it by the Purchase Price.

So, the Cap Rate formula is:

Cap Rate = Annual Net Operating Income (not including mortgage payments)/Purchase Price

Read InvestorLoft’s expanded explanation of Cap Rate.

CASH ON CASH RETURN

The Cash on Cash Return of a property is often times referred to as a property’s yield. Cash on Cash Return is a way of evaluating the return on investment of an investment property in relation to your out-of-pocket expense, based on the amount of Annual Net Operating Income the property will yield (not considering income tax) in proportion to your Down Payment and Repair Cost. The Cash on Cash Return formula is calculated by taking the Annual Net Operating Income of an investment property divided by the amount of your Down Payment and immediate Repair Cost.

So, the Cash on Cash Return formula is:

Cash on Cash Return = Annual Net Operating Income/(Down Payment + Repair Cost)

Read InvestorLoft’s expanded explanation of Cash on Cash Return.

Evaluating investment property. It stands to be a tall order to fill if you don’t know what you’re looking for! For the residential real estate investor, granite countertops and a built-in backyard BBQ island aren’t so important as the financial p’s and q’s of the purchase.

When evaluating your next potential residential investment property for your real estate investment portfolio, here are 5 key criteria to keep in mind throughout your search:

1. P/E Ratio – for what the property is going to cost you, will the annual cash flow put you in the red or the black at year’s end? You can determine this by researching average rents and vacancy rates in the area in which you’re looking to buy and dividing the purchase price by the property’s annual estimated income.
2. Accessibility – Depending on where your prospective property is located, accessibility will be key. School districts are always a top consideration and proximity to bus lines and/or public transportation and staple amenities like grocery & discount stores (think WalMart & Target) are important things to keep in mind as well. Dog parks (if you’ll allow pets), running and biking trails (think college towns like Denver and Phoenix) and family-oriented recreation like parks and public swimming pools are considerations.
3. Purchase Strategy – Are you rehabbing? Flipping? Aiming for a buy-and-hold? Knowing your goals before you buy will help you narrow-down the choices in shorter order.
4. Cash Flow – What are your needs? Some investors don’t mind a little bit of a negative cash flow when historical appreciation rates will make-up the difference upon final sale. Know what your cash flow needs are prior to getting into a place and understand that vacancy rates vary greatly between geographies. Have your Realtor do the homework for you on vacancy rates so you know what your financial carry is going to be in advance.
5. Crime Rates – Know what you’re going to own. If auto theft and burglary are off the charts, it’s going to be difficult to attract quality tennants regardless of how good a deal the property is. Your homeowner’s insurance will take a hit as well if you need to invest in repeated repairs due to criminal activity. Visit the local police station for crime stats before you buy. And don’t forget to drive-by at night!