Measuring return and analyzing an investment
An investor needs a way to compare one property with another, and with other uses for the money. Each return measure answers a slightly different question.
| Measure | Formula | Answers the question |
|---|---|---|
| Capitalization rate | NOI ÷ price (or value) | What does the property earn, ignoring financing? |
| Cash-on-cash return | Before-tax cash flow ÷ cash invested | What does my own cash earn this year? |
| Simple return on investment (ROI) | Gain ÷ amount invested | How much did I make over the whole holding period, as a percent? |
| Debt service coverage ratio | NOI ÷ annual debt service | Can the property carry its loan? |
Capitalization rate as a return measure
The cap rate is the property's annual return if the buyer paid all cash. A $400,000 building with $32,000 of NOI has a cap rate of 8%. Because it uses NOI, which is measured before debt service, the cap rate is the same no matter how the buyer finances the deal. That makes it handy for comparing properties side by side.
Higher cap rates generally go with higher risk: buyers pay less per dollar of income for a property they consider riskier. Unit 16 covers using the cap rate to estimate value (value = NOI ÷ rate). Here, just treat it as a return.
Cash-on-cash return
Cash-on-cash looks at the investor's own money. The top of the fraction is before-tax cash flow (NOI minus debt service). The bottom is the cash the investor actually put in, usually the down payment plus any cash closing costs the problem tells you to include.
Using the same $400,000 building: the investor puts down $100,000 and borrows the rest, with annual debt service of $22,000.
- BTCF: $32,000 − $22,000 = $10,000
- Cash-on-cash: $10,000 ÷ $100,000 = 10%
The cap rate is 8% but the investor's cash earns 10%. That gap is positive leverage at work.
Simple return on investment
For a property bought and later sold, the simplest measure is:
ROI = (sale price − total investment) ÷ total investment
Total investment includes the purchase price plus capital improvements, if the problem gives them. A lot bought for $150,000 and sold for $195,000 returned $45,000, or 30% of what was invested. This is the same idea as percent profit in Unit 14: always divide by what was invested, not by the sale price.
Simple ROI ignores how long the money was tied up. Thirty percent over one year is far better than 30% over ten years.
How an investor analyzes a deal
Before buying, a careful investor asks:
- Is the income reliable? Look at the leases, current and projected vacancy, and the tenants' strength.
- Are the expenses realistic? Sellers sometimes leave out reserves or management.
- Does it cover the debt? Lenders look at the debt service coverage ratio. A ratio below 1.0 means the owner must add cash to make the payments.
- What is the risk, and is the return enough to pay for it? Riskier properties should offer higher expected returns.
- How liquid is it? Can the owner sell in a reasonable time if needed?
- What about time? A dollar received today is worth more than a dollar received years from now, so investors prefer returns that come sooner.
- How does it compare? The investor compares the expected return with other investments of similar risk.
Exam tips
- Cap rate uses NOI and price. Cash-on-cash uses cash flow and cash invested. Mixing them up is the classic trap.
- If you see "return on equity" or "return on the cash invested," use cash-on-cash.
- If a problem says the loan is interest-only, debt service is just loan × rate.