When looking at buying an RV park, there are three units of mathematical comparison that are the most important: 1) cap rate 2) cash-on-cash, and 3) cash flow. In this RV Park Mastery podcast, we will drill down on what these are, how to calculate them, and what they mean when acquiring an RV park property.
Episode 75: The Three C’s Of Numerical Analysis Transcript
When evaluating any deal, there are three Cs you have to work on, cap rate, cash-on-cash and cash flow. This is Frank Rolfe, the RV Park Mastery Podcast. We're gonna talk about what these three metrics mean and how they're very, very important if you're trying to buy the right deal to meet your goals. Let's start off with the concept of the cap rate, the first C, what is a cap rate? A cap rate is basically just a fraction. It's a fraction, which is made up of the net income from the RV Park on the top, and the total cost of the RV Park on the bottom. And you simply divide the top by the bottom, and that gives you the cap rate. For example, if you're looking at an RV Park, it has a $100,000 a year of net income, that would be the top part of the fraction. And it cost $1,000,000, that's the bottom part of the fraction. I divide then 100,000 by 1,000,000. And what do I get? I get 0.1, which means I have a 10% cap rate.
Let's change the numbers for a minute, let's say that the top of the fraction is 100,000, but the bottom is now, instead of 1 million, 2 million, what do I have? Now, I've got 100,000 divided by 2 million. What do I get? I'm gonna get 0.5. And that represents a 5% cap rate. So why do I care? What's a cap rate showing me? Well, cap rates have become... Of all the different metrics you have out there, probably the most popular way to analyze competitive deals to see which is the better, and when you're a buyer, the higher the cap rate, the better. When you're a seller, the lower the cap rate, the better. Because when you're the seller, you'd much rather they have the $2,000,000 in your hand, at a five cap, than you would selling it for 1,000,000 at a 10 cap. And when you're a buyer, it's the reverse.
When you're looking to buy in an RV Park, you always wanna shoot for the highest cap rate you can get. Now, there's other criteria beyond that, but in two identical deals at different cap rates, the higher one always wins. That's the world of the cap rate. Now, then you move on to your cash-on-cash return. Now, what is that telling us? The cap rate told us a return level on the whole price of the deal. What is the cash-on-cash really creating? What that is telling you is, what is the return on your down payment. Because the word cash-on-cash, that cash is your down payment plus any supplemental costs, you have to put into the RV Park.
Now, why is that important? Well, because all of us as investors, we're looking at the return on our capital. If I put $300,000 in a CD at 3%, or I can put 300,000, in a treasury at 4%, I'm gonna go with the treasury because the higher the return, that cash-on-cash return on my cash, that's what I'm after as an investor. Now, one interesting thing you have to know about the cash-on-cash is, cash-on-cash, you add back in your principal portion of your mortgage. Now, why would you do that? Let's say that you buy that RV Park and you buy it a 10% cap rate, and then your cash-on-cash, when you do the calculation, you're making your mortgage payment. But you have to do something with the principal portion. The principal portion, well, it has to go somewhere.
Where does the principal portion go? Well, it goes ultimately in your pocket, because you're paying down your loan at the bank. So when you go and you pay the whole Park off, in the end, it goes in your pocket. If you sell the RV Park, it goes in your pocket, if you refinance the RV Park, you're outstanding loan balance, it's still in your pocket. Even though you don't get that principal portion of the note in your pocket right now, it's still being safely put in the bank for your later enjoyment. Some people call that a enforced savings, is what some people talk about that concept, because what's going on is the bank is making you save that money every month, because you gotta put it in there as the principal pay down on your loan. But that's what cash-on-cash is. But then there's a third C, and that's called cash flow. Now, what is cash flow? Cash flow would be your revenue, less your expenses, less everything, and even less, both principal and interest on your mortgage payment. The cash flow basically tells you monthly, how much money you're gonna have left over at the end of the day when you get done paying all the bills. That's the amount that can actually go in your pocket.
Now, let's talk about the interplay between those three Cs, how does that work? How can you have things look on the surface successful but your failures and vice versa. Well, let's start off with the cap rate and the cash-on-cash returned. It is possible to buy something at a very high or high-ish cap rate and still not having a steadily high cash-on-cash return. And that's because of the concept of leverage. Everyone who buys real estate for the most part, always puts leverage on it, even your rates, your real estate investment trust, which are very low levels of debt, they still use 50% normally. Now, real estate is attractive because of its ability to get leverage, you can't do it on a lot of other kinds of things that you could buy, you can't typically get big mortgages on a business because banks are terrified about a business, so they might give you some a little bit of leverage. But they're not gonna give you a big old 30-year loan on you buying a pizza shop.
Because for all they know you'll fail in the first year, or you'll fail in the fifth year, which is what most US businesses do. Or you'll certainly, probably fail by the 10th year, they can't have a 30-year note on that. But in the RV Park business, having large amounts of leverage is common, and the cash-on-cash return, therefore, is based on how much cash you put in. And the amount that you do, the way the loan is structured can have a huge impact on that. For example, if I do a zero down deal and we've done 12 zero down deals over the last 30 years, that zero down deal has an infinite cash-on-cash return. Why? Because I got no money in it, not a penny. So if I have no money in it by rate of return, if I only got one dollar back would be effectively infinite. The amount of down payment you put down will have a lot to do with your cash-on-cash return and how attractive that overall return is for you. In fact, the difference between the cap rate and interest rate on your loan will also tell a whole lot. If you bought an RV Park at a 5% cap rate, and then you borrowed at 6% interest from the bank to buy it, then you'd have a reduction in your cash-on-cash return. You might have a negative cash-on-cash return, you might have to feed that loan.
Just because you have a strong cap rate doesn't mean necessarily you'll have a great cash-on-cash return. If you buy a part for all cash, instead of having an infinite return, like a zero down deal, if you pay all cash, then you're gonna have the lowest possible return you can get. Because you have no leverage to help spike that return at all. Let's talk now about the interplay between cash-on-cash and cash flow. Can you have a very strong and healthy cash-on-cash return and still have negative cash flow? Yes, you can.
Well, how is that possible? Well, if I have a short amortization on that loan, instead of a 25-year amortization as most RV Parks would, let's assume I have seller finance, and he changes it around to a 10 year. What happens to me? Well, the principal portion of my mortgage goes way up, not the interest, remember the interest is set, but the principal portion would be much bigger in that case. And since I have a much bigger principle portion, then I have much lower cash flow after principal. If I set the amortization of super short, in fact, I might have a very strong cash-on-cash return to have a negative cash flow. Because you don't include the pay in the pay back or the pay down of your debt when you use the cash flow analysis. Now, what are some other thoughts on that... Well, cash flow at the end of the day is very, very important to you, because you don't wanna buy an RV Park that negatively cash flows. That would be a problem, you have to very seriously at all three metrics.
You can't just say, "Well, the cap rate is strong and my cash-on-cash is attractive." Okay. But what about your cash flow? Do you have enough money after paying the mortgage payment to have something left over. And then, of course, there are some other issues you have to think about. One of them is, What can I do with this property after I buy it? Because what I can do with it as far as changing that net income, the top part of the fraction is gonna do me a world of good on all of those Cs. Suddenly the cap rate goes up because I have greater dead income, or my cash-on-cash goes up, because I have more money that goes in my pocket even after my enforced savings of that principal portion every month. And then the cash flow is the other huge winner. A lot of times what you can do with an RV Park after purchase has a huge impact on those three Cs. And obviously financing also has a huge impact, the way you finance it and the amount of down payment you utilize and the amortization linked of your loan is all telling on how things work out. The bottom line to it is that there's many things you have to analyze in doing the due diligence on an RV Park, many methods of comparison between two apples to apples RV Park and which one you should buy.
But those three Cs, you've gotta have a mastery of those if you do not know the cap rate, the cash-on-cash return and the cash flow in any RV Park that you look to buy and to operate, then you're really missing out. And when you go out to get your loan, you better believe the bank is probably gonna ask you to make sure you have a mastery of those three Cs. This is Frank Rolfe, the RV Park Mastery podcast. I hope you enjoyed this. Talk to you again soon.