You’ve scoured the market for weeks. Monitored the listings, reviewed offerings from brokers and toured multiple properties. At this point you know the market cold and are confident that the property you’re under contract on is a steal, significantly under priced vs the comps. The only question now is; how much are you going to actually make on this deal.
There are a number of ways that real estate investors calculate their returns on an investment. Some metrics are better used in certain situations, or when viewing from a certain perspective than others and more often than not an investor will use multiple metrics to analyze their deal.
In this post we’re going to look at an investment metric known as “cash on cash return”, what it is, how to calculate it, and why it’s used.
Cash on Cash Return: The Basics:
Cash on cash is one of my favorite tools for quickly analyzing a real estate investment. It’s quick and easy to calculate and it very simply lets you compare and decide between different investment opportunities.
Cash on Cash calculation (no debt):
Cash on cash is simply calculated as cash flow before taxes divided by total cash invested. Let’s look at a building purchased all cash for $1,000,000 with year one annual income of $100,000. Without leverage (debt) cash on cash return will be 100,000/1,000,000 = .1 = 10%. It’s a very simple calculation and properties or investments in other asset classes can easily be compared.
Cash on Cash calculation (with debt):
The use of leverage (debt/mortgages) is one of the major benefits of investing in real estate, and looking at cash on cash after debt shows why. Let’s take the same example above but instead of paying all cash for the property you get a loan for 800,000 and use $200,000 of your own cash for a down payment. Let’s assume that the terms you negotiated with the bank require monthly payments which amount to $50,000 annually.
Here, you have $50,000 of free cash flow remaining instead of the $100,000 in the all cash example. This time, however, you only put in $200,000 of your own money so your cash on cash return is 50,000/200,000 = 25%.
Of course the numbers are simplified for ease of understanding but you can see the power of using debt and its effects on overall cash on cash return.
Cash on Cash Limitations:
This metric when used to compare investment opportunities does not take into account the varying levels of risk inherent in each property. While the returns of new ground up development or a “war zone” multifamily may significantly exceed those of buying a triple net leased credit tenant retail property, it does not adequately tell if these projected superior returns are worth the associated risks. An investor cannot simply conclude that an investment offering 12% cash on cash is superior to one providing a 6% return without taking into account the additional risks involved to earn the higher returns.
This simple calculation also does not account for appreciation and depreciation which may differ between properties. Cash on cash return also doesn’t consider equity buildup as a result of mortgage payments paying down the original loan balance.
Another area where cash on cash alone doesn’t tell the whole story is when looking at extended time horizons, especially with changes to the income stream. For example consider the same property as before but now also look at year two income. Suppose that you have a rent bump with in your lease and now year two provides $200,000 income before debt service. If your purchase criteria only looks at initial cash on cash returns then you would miss out on this potentially lucrative opportunity. To look at multiple year returns a discounted cash flow analysis is the better tool to use. I’ll go over discounted cash flow in another post.
Cash on Cash returns: Conclusion
Cash on cash is a very powerful tool to quickly gauge the attractiveness of an investment. It shouldn’t be the only criteria you use to make an investment decision, however. Rather cash on cash returns should be used as a screening tool to see if an investment warrants further analysis and investigation.