What Beginning Real Estate Investors Should Know About Cash on Cash Return
To begin with, beginning real estate investors should know that cash on cash (CoC) is not a particularly powerful tool for measuring the profitability of rental income property.
Its shortcoming, perhaps, being due to the fact that cash on cash return doesn’t take into account time value of money–cash-on-cash return must be restricted to measuring a property’s first year, and not its future year’s, cash flow.
Nonetheless, cash on cash is not without validity and still offers seasoned and beginning real estate investors a benefit long attributed to its popularity:
Cash on cash return provides an easy way for real estate investors to gauge the profitability of a real estate income property against another investment opportunity, and can help investors quickly compare the profitability of similar real estate income-producing properties.
About Cash on Cash
Cash-on-cash return measures the ratio between anticipated first-year cash flow to the amount of initial cash investment made by the real estate investor to purchase the rental property. Hence cash on cash is always expressed as a percentage.
Okay, now understand the two components used for the return.
The first-year cash flow is the amount of money the property is expected to generate during the first year of operation (fairly straightforward).
More confusing, however, is what constitutes initial investment. Understand that it is not cash down payment alone. Rather, it’s the total amount of cash the investor expects to invest to purchase the property (or cost of acquisition) and includes loan points, escrow and title fees, appraisal, and inspection costs.
How to Calculate Cash on Cash
Annual Cash Flow / Cash Invested = Cash on Cash Return
For example, let’s assume that you’re interested in purchasing six units each paying $1,000 per month rent. Annual expenses are $28,800. Your financing includes a $126,000 down payment, loan points of $2,940, and a monthly mortgage payment of $1,956. Closing costs are $2,100. How do you calculate your cash on cash return?
First, calculate your annual mortgage payment: $1,956 for twelve months is $23,472.
Secondly, calculate your annual cash flow: Six units at $1,000 for twelve months is $72,000, less annual expenses of $28,800 is $43,200, less annual mortgage payment of $23,472 equals an annual cash flow of $19,728.
Thirdly, calculate your initial cash investment: Down payment of $126,000 plus loan points of $2,940 plus closing costs of $2,100 equals $131,040 cash investment.
Finally, calculate your cash on cash return by dividing annual cash flow of $19,728 by cash investment of $131,040. Your cash on cash return is 15.06%.
Conclusion
Real estate investors should not rely solely on cash on cash return when making real estate investment decisions, and are advised that there are better ways to evaluate income-property investments.
Still, cash on cash is easy to calculate and does allow a quick comparison to alternative investments such as a T-Bill rate. Moreover, there may come a day when you encounter a buyer for your property who does highly deem cash on cash return.
So it certainly helps to be aware of it, to learn how to calculate it, and to include it in cash flow analysis reports. Who knows? This basic investment measure may be just what you need to close your next deal.
Author: James Kobzeff, December 23rd, 2006
