May 16, 2022
Basics of Cash-on-Cash Return for Real Estate Investors
When looking at a new real estate investment property, it is important to provide justification for the purchase. That is where financial metrics assist by breaking down past performance and projecting future earnings of the property. However, understanding and implementing these metrics can be difficult to do.
This article seeks to alleviate some of that pressure by defining and providing use cases of cash-on-cash return.
- Cash-on-Cash Return describes the relationship between the total cash flow during a time interval and total cash initially invested
- Cash-on-Cash Return is a levered metric usually calculated on an annual basis for real estate investments
- Cash-on-Cash Return measures the annual pre-tax return from real estate investment based on investor's capital
What is Cash-on-Cash Return?
Cash-on-cash return describes the rate of return for the total cash flow during a period over the total cash initially invested. In the real estate context, cash-on-cash return is the ratio of the investor's equity divided by the investor's return from the property after expenses and debt.
Most of the time, real estate investors will calculate total cash flow on an annual basis to standardize the revenues and expenses.
Cash-on-cash return formula looks like:
What is Total Annual Cash Flow?
Total annual cash flow gives a snapshot of the inflows and outflows from owning the property. Total annual cash flow is the one-year figure of the revenues generated by the property minus the operating expenses and mortgage payments.
The revenues come from rent and other income sources such as amenities, parking fees, and vending machines. The operating expenses depend on the costs of maintaining the property such as accounting fees, repairs, and insurance.
A quick calculation of revenues minus the operating expenses gives net operating income, a financial metric indicating the profitability of the property.
The loan agreement defines the interest rate, term of the loan, and size of the loan, which dictate the magnitude of the mortgage payments.
An easy-to-remember formula for total annual cash flow is:
If the property is bought in all cash, then the mortgage payments would equate to 0.
Important Fact: Total annual cash flow does not include capital expenditures (large repairs and upgrades), amortization, and depreciation as those expenses differ by the year and choices of the investor.
What is Total Cash Invested?
Total cash invested depends on the investor's choice of financing for the property and the amount willing to invest. Unfortunately, costs such as closing costs, broker fees, and potential initial repairs can not be avoided and are accounted for in total cash invested.
What is an Example of Cash-on-Cash Return?
Cash-on-cash return can be utilized when analyzing a potential investment. Let's walk though an cash-on-cash return example:
Assume we are looking at a multi-family home investment property. The house generates $5k per month from rent and costs $1k per month to maintain. The house is being sold at $300k and closing costs will be $10k.
We are able to receive a 30-year loan with a 20% down payment and an interest rate of 7%. Therefore, the monthly mortgage payment is $2k.
First, we need to calculate the monthly net operating income by subtracting the operating expenses from revenues:
Now, we need to determine the total annual cash flow by taking the monthly net operating income minus the monthly mortgage payments and multiplying by 12:
For total cash invested, we simply add the down payment to the closing costs:
Finally. we can figure out cash-on-cash return by diving the total annual cash flow by the total cash invested:
With a cash-on-cash return of 34.29%, the investment property seems to have a reasonable return, but to arrive at a conclusion we should perform a comparative analysis with other properties, using financial metrics such as cap rate and debt service coverage ratio.
What is the Use of Cash-on-Cash Return?
Leverage is a useful tool to utilize as a real estate investor to avoid putting large amounts of capital upfront. Cash-on-cash return is a levered metric, which allows the investor to gauge the effect of debt financing on their return. The more equity an investor holds the more cash-on-cash return decreases.
Cash-on-cash return highlights the inflows and outflows of the property. The total annual cash flow indicates the worth of the investment based on operations and the investor's financing. An investor can determine if the property produces a profitable return by a positive total annual cash flow.
Cash-on-cash return can project future cash distributions based on the growth or shrinkage of the factors that influence total annual cash flow. Inventors can implement this projection by researching past growth rates for revenues and operating expenses in previous owners' rent rolls and financial statements. The forecasted cash-on-cash return indicates potential returns, not guaranteed ones.
What is a Good Cash-on-Cash Return?
With financial metrics, the go-to answer for this question is it depends. Now, cash-on-cash return is no different, but to determine a reasonable return for the property an investor can account for these factors:
Market - The geographic location and broader economic conditions drastically influence supply and demand for properties. By understanding the market type, investors can rationalize the cash flows and property values. To understand a market, an investor has to research the short-term and long-term sales of properties, inflation rates, and taxes. Key resources to find this information come from brokers, contractors, and past owners.
Property Type - An underrated factor but holds a similar effect on cash-on-cash return as the market. Demand for specific properties, dictated by external economic factors highlighted above, influences the values of property types. Certain property types such as apartment buildings have higher cash flows compared to single-family homes. However, the property values for these larger buildings can offset the higher cash flows, resulting in larger cash invested. The best way to understand the property type stems from research of similar property types.
Equity - The magnitude of equity depends on the investor's choice of financing. The more debt an investor uses the higher the cash-on-cash return and debt leverage ratio rises, which can deter lenders from issuing a loan. The investor has to be careful in finding enough equity that does not dissuade lenders and provides a substantial cash-on-cash return.
Operation and Management - The past owner's decisions for rental rates and operating costs change the total annual cash flows. For instance, the landlord may conduct all the minor repairs, driving operating costs lower, potentially inflating cash-on-cash return for a different owner. To account for operation and management, understand the reasons behind the components of net operating income.
What is Unlevered Yield vs Cash-on-Cash Return?
Unlevered yield is an identical measure to cash-on-cash return for gauging the performance of a real estate investment. However, unlevered yield does not include debt service in its calculation.
Therefore, the formula for unlevered yield looks like:
An investor can see the influence of leverage on an investment by measuring unlevered yield and cash-on-cash return. The use of leverage is up to the investor and depends on the investor's capacity of risk.
Important Fact: Yield means rate of return