Key Real Estate Terms Investors Need to Know When Evaluating Investment Opportunities

When investing in commercial real estate, you're sure to come across key investment terms you'll need to have a handle on when evaluating opportunities-most notably, "cash-on-cash return," "cap rate," and "cash flow."

These are analytics that investors often utilize in evaluating potential commercial real estate investments to decide whether or not they'll make the purchase.

Here's an explanation of what each one means.

Cash-on-Cash Return

The final step in putting all of this information together is determining the "cash-on-cash return"-the rate for annual cash flow divided by down payment for the property. So in the same example, if you made a down payment of $300,000 to purchase the property, with the annual cash flow having been determined as $20,000.00, your cash-on-cash return would be $20,000 divided by $300,000-or 6.67%.

Whenever the cap rate rises for a specific property, with all other things still being equal, the cash flow and the cash-on-cash return for the property will rise, too.

All of this then comes together with the purchase price, down payment, net income, interest rate and monthly loan payments.

To give an example of how one variable can affect the entire scenario: If interest rates were to rise, the cap rate would remain the same, but the cash flow for financed deals would diminish because of the higher total annual loan payments on the property. When something like this happens, all-cash buyers can end up in a better position, because their competitors who needed financing to purchase can't make the potential investment pencil out as well at the new, higher interest rates.

Knowing cap rate, cash flow and cash-on-cash return can help you determine if a property is a good potential investment. More data is always better, since you want to make the wisest decisions you can when investing in commercial real estate.

Cap Rate

"Cap rate" is a fundamental term to understand. It's a basic measure of the return on investment for a property, determined by dividing the net income of the property by its purchase price. So, for example, if a property that you are considering buying has a price of $1,000,000 and the annual net income on the property is $80,000, the cap rate would be 8%.

Cap rates vary depending on how hot the real estate market is at any given time. When the market is hotter, the cap rates tend to be lower, as more people become interested in buying and the overall demand for properties increases.

Conversely, when the market cools off, owners will oftentimes need to sell their properties at a higher cap rate, because the number of interested buyers will typically be lower. Less favorable economic conditions can often cause the remaining buyers to demand better prices.

If you'll be paying all cash, this is the only one of the three terms defined in this post that you'll be utilizing. The other two terms, "cash flow" and "cash-on-cash return," are utilized when you receive financing to complete your purchase.

Cash Flow

The term "cash flow" refers to how much cash the property will generate annually for you after all expenses are taken into consideration, including all of your loan payments. So in the previous example of the $1,000,000 property, if the annual loan payments are $60,000, the annual cash flow on the property would be $20,000, based upon deducting that $60,000 from the property's annual net income of $80,000.

This article was updated on 12/12/2024