If you're thinking about buying a rental property, you need to know how your investment is going to perform in order to decide if it's worth purchasing. One method that investors will use to quickly evaluate whether a deal is worth investing in is Cash-on-cash return.
Cash-on-cash return is a simple metric: It's the amount of yearly cash flow you receive after all your expenses, divided by the total amount of cash you invested in the deal.
While this can be a great tool for evaluating deals, it only works in some situations — and can expose investors to significant risk if it's the only metric used to evaluate property.
In this article I'll cover what I consider to be a good cash-on-cash return that I look for in my personal investments, plus offer up a few examples that show when you should and shouldn't use cash-on-cash return as the guiding metric in your analysis.
The formula for calculating cash-on-cash return is simple.
You find your yearly cash flow by taking the income from your investment and subtracting all expenses like maintenance, repairs, taxes, insurance, and even your mortgage payment.
You then take that number and divide it by the total cash outlay you made to initially purchase the property. Expressed as a formula you get:
(Property Income - Property Expenses) / Total Cash Investment To Purchase
While using the formula for cash-on-cash return when you have all the inputs is easy, calculating the returns of a prospective investment is a lot harder.
You have to be able to estimate your rental income, vacancy, and expenses for repairs and maintenance.
While this can be difficult, I built a free rental property calculator you can use to estimate this.
This tool makes it easy to estimate your cash-on-cash return with a simple feature that models all of your expenses. It takes into account your:
- Rental income
- Other income
- Capital Expenditures
- Mortgage payments
- Property Management Fees
- Leasing Fees
- Renovation Costs
I built this tool to model hundreds of deals as I was growing my portfolio to 22 apartments. In my opinion, it's the best way to model your cap rate and cash-on-cash return.
You can view what the output of the calculator looks like below.
When I'm looking to buy a rental property, my goals for cash-on-cash return vary based on the type of property that I'm buying.
Assuming that I'm using conventional 20% down to purchase properties, here's what I look for, based on the the location of the properties.
- In rough neighborhoods with no expectation of appreciation I look for a minimum of 20% cash-on-cash return. These properties are hard to manage, and often have a large amount of unpredictable expenses due to damage from tenants. A 20% projected return offers a good return for the risk I'm taking, as well as a margin of safety if things go wrong.
- For properties on the fringe (rough areas that I think are going to appreciate in the near future) I'm willing to accept a bit lower of a cash-on-cash return, and my minimum threshold is 15% cash on cash return.
- For properties in B or A neighborhoods I'm confident will appreciate, I have the lowest threshold, at a 9% return.
Personally, I like to own a mix of all three of these types of property to diversify my portfolio. That said, at the moment, the majority of my portfolio is either in fringe or B-class neighborhoods.
All the properties I own are in St. Louis, Missouri, and these numbers work for me in my market.
Your market might be quite different, so you should do your homework to see if your market is similar before using any of the targets I shared.
Generally speaking, if you're buying rental property in a market that is stable or appreciating, cash-on-cash return is a great metric to use.
Let's take this example scenario of a property to calculate it's cash on cash return and evaluate the investment.
|Property Location||B neighborhood|
At first glance, I notice that this property doesn't meet the 1% rule, which I usually like to see for properties in this price range and neighborhood.
I plugged all the numbers into the rental calculator shared above, and got the following results:
Looking at the results, I can see that a cash-on-cash return of only 4.24% isn't a good investment for me, when I can get 8% on properties in a similar condition and neighborhood.
While cash-on-cash return works really well for residential rental properties, it can be very risky for commercial properties.
For example, my partner and I looked at buying a building that was currently being rented to a tea room in St. Louis that was doing really well.
The building was in great shape and was tax abated for another five or so years, and the tea room had a similar amount of time left on the lease.
The building was offered at a price that, thanks to the tax abatement and least, would yield a 15% cash-on-cash return for the first 5 years.
But after that, we would have had to raise the rent on the tenant by close to 50% to maintain the same return, which was unlikely.
The store was also expanding rapidly into online sales, and we were concerned they would grow out of the space and not renew their lease.
While the cash-on-cash return was initially appealing on this deal, making our decision based on that alone would have been similar to buying a time bomb, as the property wouldn't cash flow once the tax abatement was up.
We caught this by looking at our financial model over time, and not just using cash-on-cash return.
While I liked the idea of owning a tea room, I'll have to wait until I can find one for sale at a price that makes sense for the long term.
There's one more metric you need to consider if you're buying an investment property: Cap rate.
While cash-on-cash return looks at the return based on your invested cash, cap rate looks at the objective returns of a property based on its purchase price.
Cap rate ignores your mortgage payment and just looks at how the property would perform if you purchased it 100% in cash.
I recommend using both cap rate and cash-on-cash return to evaluate your deals.
It's important to make sure you're getting a great cash-on-cash return while also getting a good cap rate, as when you go to sell the property, it is going to be priced based on the cap rate — not your cash on cash return.