CoC and Cap Rate Correlation

[Yaya Y.]

Hi everyone,

I was looking at an investment property that returned a 5% cap rate after renovations. 

The cash on cash return is basically 1%

Can everyone give their two cents to what their cap rate is on your properties as well as the CoC return. What is the correlation?

I don't see how a 5 cap (which is a decent return for today) achieves such a low CoC.

Note: I am putting 35% down once the building is stabilized. 

[Immanuel Sibero]

@Yaya Y.

I would say CoC and Cap Rate are not correlated, at least not directly. As a matter of fact they might even be apples and oranges. CoC is an "investor" specific metric, whereas Cap Rate is an "asset" specific metric. CoC measures how well the investor performs and Cap Rate, in general, measures how well the asset performs. For example a common strategy in real estate investment is to find a well performing asset with a good cap rate (i.e. good property level return) and further enhance this return by financing/leveraging it so as to yield even higher CoC (i.e. investor level return).

So conceptually we can say that when Leverage = 0 then CoC = Cap Rate. This is why many investors define cap rate as the expected return (i.e. CoC) if you were to pay all cash for the asset. Once you add leverage to the picture you then start to see CoC come alive. It may interest you to see the examples below how leverage affects CoC. Note that Cap Rate in this case is held constant at 5% so no correlation to CoC is observed.The sensitivity tables below were run in Excel using actual property data.

- Effect of leverage on CoC. Higher leverage leads to lower CoC. Notice that when Leverage = 0%, CoC = 5% which is also equal to Cap Rate.

Leverage	COC
0.00%	5.00%
15.00%	4.87%
25.00%	4.76%
35.00%	4.61%
45.00%	4.40%
55.00%	4.11%
65.00%	3.64%
75.00%	2.81%
85.00%	0.86%
95.00%	-8.87%

- Effect of Cap Rate/Interest Rate spread on CoC. This is assuming the typical 75% leverage. Higher spread of (Cap Rate - Interest rate) leads to higher CoC. Notice how easy it is for CoC to approach 1%. All you have to do is get a loan with interest rate approaching the Cap Rate. For example, if you were to finance a 10CAP property with a 9.5% interest loan, you would likely end up with very low CoC.

Spread of Cap Rate - Int Rate	COC
4.00%	8.42%
3.00%	6.69%
2.00%	4.82%
1.00%	2.81%
0.00%	0.67%
-1.00%	-1.59%
-2.00%	-3.95%

NOTE: The above sensitivity tables are meant to show the general nature of the correlations between CoC and Leverage (i.e. direct or inverse). Your specific property would likely calculate different CoC numbers but the nature of the correlations shown should be the same.

Cheers... Immanuel