When reviewing a potential real estate investment opportunity, or the performance of an existing investment, one of the indicators that should be considered is Cash on Cash Return.
The formula for Cash on Cash Return is the Cash Flow divided by the total Cash Investment.
Cash Flow / Total Cash Investment = Cash on Cash Return
While the math is straight forward, here are four keys necessary to really understand Cash on Cash Return.
1. The Two Factors in the Equation – Cash Flow and Cash Investment
First, we need to understand the two numbers that go into the Cash on Cash Return equation.
That is, the total Cash Investment and the Cash Flow.
The total Cash Investment is the amount of our own money we put into the purchase. This includes everything we pay upfront and in the process of getting the property ready to rent. Its not necessarily just the purchase price if we pay all cash. Nor is it only the initial 20% or 30% down payment if we purchase using a loan. The total Cash Investment includes down payment, closing costs, lender fees, renovation costs, and any other out-of-pocket costs that we are putting into the investment.
The Cash Flow is the amount of net income that is being generated by the investment once it is operating, and after all operating expenses and debt payments. That is, at the end of the month or year, after the operating expenses and debt payments have been paid, how much actual cash income is left? That number is the Cash Flow.
2. There are actually two versions of Cash on Cash Return
One version includes the profits from the sale of the property and the other version does not.
When we calculate Cash on Cash Return and include the profits from the sale of the property, it will take into account the property’s equity at the time of sale. Therefore, this number will indicate how much money we have made (or are projected to make) over the life of the investment (e.g., 5 years).
The 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.
3. Debt Service
When there is debt on the property, only the annual payment on the debt and not the total debt amount, is considered when calculating the Cash on Cash Return.
This is because the annual debt payment (also known as “debt service”) is factored into the Cash Flow formula.
For example, we purchase a 20-unit apartment building for $2,250,000. In this deal, we invest $850,000 cash, which includes the down payment, closing costs, lender fees, and minor renovation costs. We get a commercial loan for the remaining $1,400,000.
After operating the apartment for the first year, our Cash Flow is $92,000 after all operating expenses and debt payments. Therefore, the Cash on Cash Return is $92,000 / $850,000 = 10.8%. Notice in this example, the bottom number is ONLY our cash investment, not the total purchase price of the property. It does not include the debt amount.
4. A Pre-Tax Measure
It is important to know that Cash on Cash Return does not factor in taxes. It is a pre-tax measure of return on investment.
Cash on Cash Return can be a very straight forward calculation of how much real money we get to take home as an Investor, before paying taxes. For Investors interested in cash flowing real estate, this makes it 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].