Resolve Conflict in Calculating Cap Rate and Cash on Cash Return

[E. C. "Stony" Stonebraker]

I read the 2010 article by J Scott titled "An Introduction to Real Estate Investment Deal Analysis" and I'm also reading the book "The ABCs of Real Estate Investing..." by Ken McElroy.  The two sources calculate Cap Rate and Cash on Cash Return differently.

Cap Rate by Scott is NOI / (Purchase Price + Improvements + Closing Costs)

Cap Rate by McElroy is NOI / Purchase Price.

Cash on Cash Return by Scott is Cash Flow / (Down Payment + Improvements + Closing Costs)

Cash on Cash Return by McElroy is Cash Flow / Down Payment.

Which is the preferred calculation?  Does it depend on flipping vs Buy and Hold?

[J Scott]

As a business guy in general, I look at cap rates much the way Roy mentions above.  To me, it's similar to how businesses use "gross margins" -- the gross margins of a business isn't going to tell you much about the efficiency of that business, EXCEPT as compared to other similar businesses in the same industry.  The fact that Walmart has 25% margins and eBay has 75% margins tells you nothing about the efficiency of either business, except when you compare -- for example -- Walmart's margins to Targets' margins or eBay's margins to Alibaba's margins.  

Likewise, with cap rates, they're meaningless in a vacuum.  Just looking at the cap rate of an apartment building in Atlanta or a strip mall in California tells you nothing (they may be similar or vastly different, but that's just coincidence).  The value of the cap rate metric comes when you compare -- for example -- the cap rate of an apartment building in Atlanta to another SIMILAR apartment building down the street from it.  And, when doing that, it doesn't matter exactly how you calculate cap rate for each building, as long as you do it the same way for both (since you're making a comparison).  If one is 10% and the other is 8%, those specific numbers are pretty unimportant -- but the fact that one is a good bit higher (or lower) than the other is what's important from a tactical standpoint, given that they were calculated in the same manner using the same types of data.

As for cash on cash return, that's a little more important (in my opinion). The purpose of a COC is to be able to compare a cash flowing real estate investment to another cash flowing investment. Am I getting a better return on that rental property than if I took the same amount of cash and put it in a CD? Or put it in a dividend yielding stock? Or in another rental property!

In order to make that comparison, I have to assume that:

1.  I put in $X

2.  I received $Y in annual cash flow

To make it apples-to-apples, the $X needs to be consistent -- how much did I sink into the investment in total? While just looking at COC on just purchase price *may* give you a metric that's meaningful in some respects, it won't allow you to compare the investment to other investments.

For example, let's say you spend $100K on purchase, $40K on rehab and $10K on closing costs. You receive $15K per year in cash flow. While the 15% COC return on the purchase price might be an interesting metric, it doesn't give you anything meaningful based on the fact that you are OUT $150K and if you had put money in a CD or stock, it would have been $150K you needed to put in to make it apples-to-apples (that's the amount of money that left your bank account to allow the investment to start cash flowing). So, the 10% COC return number ($15K cash flow on $150K investment) is the important one here.

EDIT: Just re-read the above, and realize that I didn't say the COC stuff very succinctly...let me know if that didn't make sense.