Calculating cash-on-cash return is simple. You simply divide the received net cash flow for the year by the amount of cash invested.
Because pre-tax cash flow is used in the calculation, investors should be aware of the tax treatment of their investment. If the cash on cash return calc is low, high taxes may erase any potential investment returns.
Why Cash on Cash return is a good metric
Your first step, when analyzing a potential investment property, should be to calculate the cash on cash return.
Here are a few reasons why:
Simplicity - Cash on cash return is simply the physical cash you have in hand after 12 months, divided by the physical cash you’ve invested. It’s a prescreening tool for rental property owners that can instantly give you a good idea of how lucrative an investment property may be.
Comparing properties - It provides you with a speedy and simple way to measure the long-term profitability of multiple investment properties all at once. This allows you to more easily choose the investment property with the highest potential return.
Adding up expenses - Cash on cash return helps you to think ahead about the expenses associated with a potential investment property. Whether expected or unexpected.
Answering financing questions - Cash on cash return is a great indicator of the effect of leverage. This is because it's only looking at the net cash flow and comparing it to the actual amount of cash invested.
Cash on Cash return example
Say you're looking to buy a duplex for $300,000.
Below is the step-by-step process to calculate your cash on cash return:
On the $300,000 duplex, you decide to put in a down payment of 20%, or $60,000, and finance the rest.
Taking into account closing costs, a bit of rehab, and loan fees, that takes the cash invested number up from $60,000 to $70,000.
Next, you want to calculate the net cash flow. You know that the home is currently being rented for $2,000 a month and grosses $24,000 annually.
You then want to add up the annual expenses associated with the rental property. This includes plumbing, insurance, utilities, etc. Those expenses total $4,000 per year.
Then, calculate annual debt costs. Remember, you put down $60,000 and took out a mortgage to finance the remainder of $240,000. A 5% interest loan on $240,000 financed is equal to $12,000.
This takes your total annual expenses to $16,000 ($4,000 in operating expenses plus $12,000 in mortgage payments).
Your annual net cash flow ($24,000 of gross returns minus $16,000 in expenses) equals $8,000.
In this example, your cash on cash return is 11.4% ($8,000 / $70,000).
This means the property’s annual profit for that year will be 11.4% of the cash initially invested.
The downside of using Cash on Cash return
While cash on cash return is a very simple real estate ROI calculation to compare properties, it does have its downsides:
It doesn't factor in appreciation - Cash on cash return does not factor in property appreciation. Appreciation is one of the most important aspects to think about when buying a rental property. It’s entirely possible for a property with poor cash flow and rent returns to produce excellent returns because of an increase in its market value over time. When determining how to make money from real estate investing, future appreciation should always be taken into account.
It's based on before-tax cash flows - Real estate taxes can be quite complicated. The taxable portion of your rental returns can vary greatly from one property to another.
For example, you might buy one property in California, where the state income tax at the highest bracket is 13.3%. Your next property might be in Texas, where the state income tax is 0%. Your cash on cash return would look very different in each market because of the tax differences.
It underreports your profit potential - Cash on cash return may also underreport your actual profit. This is because it doesn’t take the mortgage, principal pay-down, and appreciation into account.
It doesn't account for the time value of money or compound interest -Cash on cash return only provides insight into a building’s financial performance at a given moment in time. This snapshot is, of course, separated from other economic factors.
What is a good Cash on Cash return?
There is a consensus amongst investors that a cash on cash return between 8 to 12 percent indicates a worthwhile investment. Others argue that in some markets, even 5 to 7 percent is acceptable.
At the end of the day, it comes down to your personal preference and risk tolerance.
Say you're investing in a property in a neighborhood that's appreciating 20% per year, but you only have a cash on cash return of 3%.
In that scenario, you'd make much higher returns than if your cash on cash return was 10%, but your property was only appreciating 5% per year.
It depends on if you're able to wait until you sell the property to collect the additional income from appreciation. Or, if you're looking for more consistent cash flow throughout the lifecycle of the investment.
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