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Cash On Cash Return & What It Means For Real Estate Investors

One of the most important metrics in evaluating the profitability of a real estate investment is the cash-on-cash return, also known as cash yield or the equity dividend rate. A cash-on-cash return is an annual measure of the cash income generated by a real estate investment in relation to the amount of cash invested. It is a useful and quick metric to gain an accurate picture of the profitability of an investment property, and is often used for efficient comparisons when assessing investment properties.

REAL ESTATE • INVESTMENTS • METRICS

Cash-on-cash formula: How to calculate cash-on-cash return

The formula for calculating cash-on-cash return is simple:

Cash-on-Cash Return = Annual Cash Flow / Total Cash Invested

The annual cash flow is the net operating income (NOI) generated by the property, which is the total income generated by the property minus all operating expenses. The total cash invested is the amount of cash you put into the property to purchase it, which includes the down payment, closing costs, and any renovation costs.

Practical Example

Let’s say you purchase a rental property for $300,000, and you put down a 20% down payment of $60,000. You also spend $10,000 on closing costs and $20,000 on renovations, for a total cash investment of $90,000. If the property generates $20,000 in net operating income each year, your cash-on-cash return would be:

Cash-on-Cash Return = $20,000 / $90,000 = 22.2%

This means that for every dollar you invest in the property, you can expect to receive a 22.2% return on your investment in cash flow each year.

Advantages and Disadvantages of Cash-on-Cash Return

There are some important pros and cons to keep in mind when using cash-on-cash return as a metric for evaluating real estate investments:

Advantages:

  • Easy to calculate: Cash-on-cash return is a simple and quick metric to calculate, requiring only two inputs: the annual cash flow and cash invested.
  • Focuses on cash flow: Cash-on-cash return focuses on the cash income generated by the property, which is important for investors who are primarily interested in generating passive income.
  • Accounts for leverage: Cash-on-cash return takes into account the amount of cash invested, including the down payment and closing costs, which allows investors to see the impact of leverage on their investment returns.

Disadvantages:

  • Ignores appreciation: Cash-on-cash return does not take into account any appreciation in the value of the property. This means that it may not provide a complete picture of the overall profitability of a real estate investment.
  • Doesn’t account for taxes: Cash-on-cash return is considered a pre tax cash flow and does not take into account the impact of taxes on investment returns. This means that it may not accurately reflect the true profitability of an investment.
  • Can be influenced by financing: Cash-on-cash return can be heavily influenced by the terms of the financing used to purchase the property. For example, a property purchased with a higher down payment may have a lower cash-on-cash return, even if it generates the same amount of cash flow.

What is a Good Cash on Cash Return?

Real estate investors often aim for cash on cash returns that exceed the cost of borrowing funds, such as the mortgage interest rate. This allows them to generate positive cash flow and cover their expenses while also earning a return on their invested capital.

The specific threshold for a good cash on cash return can vary widely, but some investors may consider a cash on cash return of 8% or higher to be satisfactory, while others may target returns of 12% or more.

Tips for Using Cash-on-Cash Return

Here are some tips for using cash-on-cash return effectively in your real estate investment decisions:

  1. Use realistic assumptions: To calculate cash-on-cash return accurately, you need to use realistic assumptions about the rental income, expenses, and financing costs associated with the investment property. Be sure to factor in all the costs associated with owning and operating the property, such as property taxes, insurance, maintenance, repairs, and property management fees.
  2. Account for financing costs: Cash-on-cash return is based on the amount of cash invested in the property, so it’s important to account for financing costs, such as interest and loan origination fees. If you’re using a mortgage to finance the property, your cash-on-cash return will be lower than if you paid cash.
  3. Factor in potential risks: When evaluating a real estate investment, it’s important to consider the potential risks and uncertainties associated with the property and the local market. Be sure to factor in potential vacancy rates, rent increases or decreases, and changes in the local real estate market when calculating your cash-on-cash return.
  4. Consider your investment goals: Cash-on-cash return is just one metric used to evaluate real estate investments. Be sure to consider your investment goals and the overall profitability of the investment when making a decision. For example, a property with a lower cash-on-cash return may still be a good investment if it has strong potential for long-term appreciation or if it meets other investment criteria.
  5. Compare with other metrics: To get a more complete picture of the potential profitability of an investment property, it’s important to compare cash-on-cash return with other metrics, such as cap rate, internal rate of return (IRR), and return on investment (ROI). Each metric provides different information about the investment, and using multiple metrics can help you make a more informed decision.
  6. Look at the big picture: Cash-on-cash return is just one piece of the puzzle when evaluating a real estate investment. Be sure to consider the overall market conditions, the potential for long-term appreciation, and the specific details of the property before making a decision. Investing in real estate is a long-term commitment, and it’s important to have a clear understanding of the risks and potential rewards before making a purchase.

Cash-on-cash return vs. ROI

Return on investment (ROI) is a metric used to evaluate the profitability of an investment relative to the initial investment. It is calculated by dividing the net profit generated by the investment by the amount of the initial investment. ROI is a simple metric that is widely used to evaluate the profitability of investments across different asset classes.

Cash On Cash Return Vs. IRR

The internal rate of return (IRR) is a metric used to evaluate the profitability of an investment over time, taking into account the time value of money. The IRR is calculated by discounting the future cash flows generated by the investment back to their present value and comparing it to the initial investment. The IRR takes into account the timing and size of cash flows, making it useful for evaluating investments with complex cash flow structures.

Cash On Cash Return Vs. NOI

Cash-on-cash return helps assess the return on investment for a specific property, while Net Operating Income (NOI) provides a snapshot of the property’s operating performance and potential profitability. NOI measures a property’s operating income after deducting operating expenses but before deducting debt service (mortgage payments) and income taxes. It represents the property’s ability to generate income from its operations. NOI is calculated by subtracting operating expenses from the property’s total income, and is often used as a basis for determining property value and loan eligibility.

Cash-on-cash return is a useful metric for evaluating cash flow, however, it’s important to use this metric in conjunction with others and to consider the big picture when making an investment decision. By using realistic assumptions, accounting for financing costs, and factoring in potential risks and uncertainties, you can make a more informed decision about whether a real estate investment is right for you.

Learn more about real estate and other real assets such as infrastructure and natural resources by downloading our Guide to Real Assets white paper.

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