In the world of investing there are all kinds of metrics used to indicate how much money we’re making. We sometimes use “return on investment” or “ROI” as a catch-all in this regard. However, in the technical details, there are a myriad of numbers, factors, and percentages that provide information about our investment returns along the way.
For passive investors, it can be easy to get distracted, if not even a little overwhelmed, by all the numbers, such that you do not really know how much you’re making on your investment. But for the bottom-line, what most passive investors really want to know is, “how much real money am I making?”
When determining “real money” returns, one of the key metrics to review is the Cash on Cash (CoC) return. While there are multiple indicators that need to line up to make a great investment, many passive investors consider Cash on Cash return to be a good bottom-line ROI measure.
The math of Cash on Cash return is actually pretty simple. It is the Cash Flow divided by the total Cash Investment.
Cash Flow / Total Cash Investment = Cash on Cash Return
If you’re not yet familiar enough with those terms, it’s the amount of money you are making (“Cash Flow”) divided by the total amount of money you invested (“Total Cash Investment”). Cash on Cash return is expressed as a percentage, such as 6% or 13.5%, and the higher the better.
For example, say we purchase a duplex for $130,000 all cash, and its ready to rent on day one. The $130,000 is our Total Cash Investment. We rent both sides and at the end of the year, after all expenses have been paid, we have made $30,000 in cash income. This $30,000 is the Cash Flow. Therefore, the equation is:
$30,000 / $130,000 = 0.231, or 23.1%.
Our Cash on Cash return on this duplex investment is 23.1% in the first year.
The equation is straight forward. However, there are a few additional things to note when understanding Cash on Cash return.
First, there are actually two versions of Cash on Cash return. One version includes the profits from the sale of the property, and therefore it accounts for the property’s equity at the time of sale and will indicate how much money we are projected to make over the life of the investment (e.g., 5 years).
The other version of Cash on Cash return that excludes profits from the sale indicates how much money we are receiving (or are projected to receive) at each distribution, such as monthly, quarterly, or annually. As such, when reviewing Cash on Cash return, we need to know whether the return we’re looking at includes projected profits from the sale or not.
Second, only the annual payment on any debt, but not the total amount of debt, is considered in the Cash on Cash return formula. This is because the annual debt payment (also known as “debt service”) should be factored into the Cash Flow formula.
Third, Cash on Cash return does not factor in taxes. It is a pre-tax return on investment metric.
Finally, it is important to understand that a major limitation with the Cash on Cash return formula is that it does not account for the time value of money. That is, earning a 25% Cash on Cash return in a one-year period is very different than earning the same Cash on Cash return in a 5-year period. Fortunately, there’s another metric known as Internal Rate of Return (IRR) that solves this time-value dilemma.
In closing, Cash on Cash return is a very straight forward calculation of how much real money we get to take home as Investors, before paying taxes. Therefore, it can be a very meaningful indicator in judging an investment’s performance and comparing investment opportunities.
If you would like to receive future articles and updates via email, please [ninja-popup ID=9820]CLICK HERE[/ninja-popup].