Cash-on-cash return is the rate of return in real estate transactions. This rate of return calculates the amount of cash income earned on the amount of cash invested into a rental property.
It is one of the most important real estate return on investment (ROI) calculations and, lucky for you, is considered very easy to understand by most of the people who use it.
Defining Cash-on-Cash Return
Real estate investors calculate their cash-on-cash return to determine how well a particular one of their investment properties is performing financially. Sometimes, investors also call this method of determining ROI the “cash yield” on a property investment.
Once determined, the cash-on-cash ROI can give business owners and any potential investors good insights. This usually provides insights into any changes or adjustments they need to make to their long-term business plan for a certain property. They can also use their insights for any potential cash distributions over the life of the investment.
Investors usually use the cash-on-cash method for future planning on investment properties that involve long-term debt borrowing. This way, they can make the best possible financial decisions to maximize their profits for a particular property.
Why is cash-on-cash so important?
There is typically debt involved in a commercial real estate transaction.
Because of this, there are certain things that are essential for investors to keep in mind at all times. One is that for commercial properties, the actual cash ROI is very different from the standard ROI.
When making calculations based on the standard ROI, you must consider the total return on an investment. Yet when calculating cash-on-cash return, things are a little bit different.
In this system, you only actually measure the return on the actual amount of cash invested into the commercial property. This provides a more accurate analysis of the investment’s performance.
Investors should be able to calculate cash-on-cash investments independently. This way, they can always be on top of their portfolios and be able to pivot investment strategies if something is not working out.
How to Calculate Cash-on-Cash Return
There is a formula for cash-on-cash return:
Cash-on-cash return = net operating income / total cash investment
That is to say, cash-on-cash return is equal to the net operating income divided by the total cash investment.
The gross operating income is the annual amount of money that any one investment property generates during one financial year. However, the net operating income (NOI) is what we are after. The NOI is the annual amount of money that the property makes, taking away all of the operating expenses. Operating expenses are things like taxes, salaries, and bills.
Once you know how much money you will have left over at the end of the year, you can divide that by the total amount of cash you invested into the property in the first place.
The total cash investment is the name for all of the money that you invested to get your property up and running. This means how much you paid to purchase the property, its closing costs, its rehab costs, and its loan fees (if you needed financing to buy it).
Cash-on-Cash Return Calculation Example
Most investors use loans to pay for their properties at the onset. If, for some reason, you do not need financing for your home, you can complete the following calculation and disregard the loan.
Let’s say you purchase a $150,000 rental property and pay 25% in cash as a down payment:
Down payment = 25% x 150,000 = $37,500.
Closing and Rehab Costs
Next, let’s factor in home closing and rehab costs for the property. Let’s say they are about 5% of the total value, totaling $7,500.
So, now the total cash investment is $37,500 down payment + $7,500 closing and rehab costs for a total of $45,000.
It is important to remember that when calculating cash-on-cash return, you only use the money you put down right away! So don’t factor in the loan yet. If you didn’t use a loan, you are almost done!
Next, let’s consider the debt service of the property. The debt service is the cash required to cover the repayment of interest and principal on a debt.
Let’s say that your loan’s interest rate is 8%, so the debt service is 8% x $112,500 (the remaining balance on the loan) = $9,000.
Calculating the NOI
To calculate the NOI (as defined earlier), you need to take your annual income potential for the property and take away the loan’s interest rate.
To find your annual income potential (sometimes called the pre-tax cash flow), simply multiply the monthly rent by 12.
Let’s say the monthly rent is $2,000. So the annual rent is $24,000. It’s usually fair, for the first year at least, that you will only be able to collect 2/3 of this income. So 2/3 of $24,000 is $16,000.
So, the NOI is $16,000 – $9,000 = $7,000.
The Final Step
Finally, to understand the cash-on-cash return, all you have to do is divide the NOI by the total cash investment. So here, it would be $7000 / $37,500 = 2%.
In this example, the cash-on-cash return you will generate from this rental property if you take a bank loan for 75% of the price is 2%.
Most would agree that anything above 8% is a good ROI, but that you should try achieving at least 8-12%.
Why Cash-on-Cash Return Works (and Why It Doesn’t)
The cash-on-cash metric is very simple. It’s a good way to get a quick answer to your investment questions. You can use it as a screening tool for potential investments and get back to business partners with your answer in mere minutes.
However, the calculations don’t account for two important things: how much you will actually pay in taxes and your true loan pay down rate. These calculations don’t consider the risk involved when you make an investment.
So, while it’s a good way to get a quick answer, cash-on-cash return shouldn’t be on the only metric you use.
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