There are many ways to invest your capital in commercial real estate. You can pay all cash, take out a commercial mortgage, and/or utilize a combination of tax strategies, including a 1031 exchange and advanced line-item depreciation. When you use debt to acquire a net-lease property, the goal is to secure the best financing terms available in order to maximize your Cash-on-Cash (CoC) return. Therefore, it is important to get your financing arranged and calculate the Cash-on-Cash (CoC) return for each property you’re interested in to make sure your investment goals are satisfied before you buy a property.
To determine the CoC return, first, calculate the amount of pretax cash flow (rent minus debt service). Then divide that by the amount of cash initially invested (down payment). For example, if you earn $110,000 in rent and your debt service is $50,000, your cash flow is $60,000. If your down payment was $1,000,000, your CoC return would be $60k/$1mm = 6.00%. Keep in mind, if you pay all cash, the cap rate is your return – this CoC formula is used only when obtaining financing.
What Does Cap Rate Have to Do with CoC?
The capitalization rate, or “cap rate,” is the level of equity return on your investment. A higher cap rate means larger ROI but may also correlate to a bit more risk. A lower cap rate means less ROI, as well as potentially lower risk. If you take out a loan for any CRE property, the interest rate on the debt has more to do with the cash-on-cash return and long-term value of the investment, rather than your specific cap rate.
In an all-cash transaction, the cap rate simply compares the purchase price of the property to the income (rent) it generates. To calculate, divide the net operating income (NOI) by the purchase price to give you the cap rate, or a natural rate of return, for a single year (excluding potential debt on the asset).
Example: $100,000 (Net Operating Income)/$1,667,000 (Purchase Price) = 6.00% Cap Rate
What About CoC for NNN Investments?
If you buy an absolute triple-net (NNN) lease property with all cash, your return is simply the cap rate, or rent received, as there are typically no landlord expenses. If you obtain debt to purchase a NNN property, your CoC could end up exceeding the cap rate return of an all-cash purchase. This is known as “positive leverage.” If the combination of cap rate and interest rate terms creates this positive leverage opportunity, it could be beneficial to explore financing for your NNN purchase. Positive leverage may also create the opportunity to acquire additional assets due to a lower down payment versus an all-cash purchase. By the time you factor in tax advantages and incremental rent increases over a 10- to 20-year lease term, an advertised 6% return on an absolute NNN can ultimately amount to an 8-12% return.
NNN Investment Benefits
- Low-risk, easy income and asset stability.
- Preservation of capital.
- A predictable return with periodic rent increases.
- A strong corporate-backed lease guarantee.
- Consistent monthly income for decades.
- No maintenance, operations, or management concerns or costs.
- Tax benefits, such as the 1031 exchange and cost-segregation depreciation.
- Tangible asset and financial leverage.
- Earn income in retirement or while you work with no worries.
To Wrap It Up – Calculate CoC the Easy Way
Whether you’re new to CRE investing or have a vast portfolio, it’s important to know how to calculate an accurate CoC for each potential investment property that seems to fit your criteria. Though you can do this on your own, it’s very time consuming and can often lead to investing in the wrong property.
To ensure you buy the best property for your goals, it’s prudent to engage a Westwood Net Lease Advisor. Your advisor will get to know you and your goals and evaluate a selection of nationwide properties/tenants that fit your needs. He will examine important factors and use industry tools to calculate the real cap rate and CoC value and ensure the desired properties align with your financial and lifestyle goals – all at no cost to you. Westwood’s team is here for you from the property search to closing – contact us today for your free, no-obligation consultation. 314-997-5227