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.

The successful real estate investor never makes a real estate investment because it’s romantic. Real estate is not purchased, held, or sold on emotion for it’s neither love nor beauty that compels. As one real estate investor put it, “Only women are beautiful.”

Real estate investing is about the return on investment. And real estate investors trying to decide whether there is a potential benefit to purchase, hold on to, or to sell rental income property rely on four basic returns inherent in real estate investment property to make that decision.

Understanding these investment decision basics, where they come from, and how to calculate them is what fuels real estate investment success.

1. Cash flow. All real estate investment property ebbs and flows with a stream of money coming in from rents and other income, and money going out for operating expenses and debt service (loan payment). Cash in minus cash out results in cash flow. When more cash comes in than goes out the result is positive cash flow, and when more is spent than received the result is negative cash flow.

The goal of course, especially for the small investor without deep pockets, is to be sure the property always produces enough cash to pay the bills. Before making the investment, prudent investors should always run the numbers and look for the benefit of positive cash flow.

2. Appreciation. Another benefit of real estate investment is the tendency for real estate to grow in value over time in what is known as appreciation. Future selling price minus original purchase price equals appreciation. Straightforward enough, but smart real estate investors don’t leave appreciation to chance–they follow the income stream.

Smart investors understand that other real estate investors buy the income stream of rental property (as they do). The more income stream they can sell, therefore the more they can expect their property to be worth; the faster they can increase the income stream, the sooner the property will most likely appreciate.

Thus, successful real estate investors consider market and economic conditions, physical improvements, and operating expenses to determine the likelihood of increasing property value. The result of a favorable location, a positive shift in supply and demand, a good probability to demand higher rents or lower vacancies, or an opportunity to reduce wasteful expenditures are all issues that could effect appreciation and are carefully considered by thriving real estate investors.

3. Loan Amortization. Amortization means to reduce periodically and hence, loan amortization suggests a periodic reduction of the loan over time. Therefore each time tenants pay the rent they provide cash to pay down the debt and benefit real estate investors by virtually helping them to buy the property.

4. Tax Shelter. Real estate investment also provides an investor the benefit of being able to legally reduce annual or ultimate income taxes.

As a general rule, most costs incurred at the time of purchase are deductible in the year of purchase. All expenses you incur in the operation of the property are deductible. The IRS allows you to deduct the interest you pay on your mortgage. The IRS also assumes that your buildings are wearing out and becoming less valuable over time and therefore allows you take a deduction for that presumed decline in what the tax code calls cost recovery (i.e., depreciation).

Of course there are nuances and exceptions in all tax matters, so real estate investors should always check with a tax expert to be sure what the current tax laws are for the investor in any particular year.

Successful real estate investors are a testament to the benefit of making money with real estate investment property. You can benefit, too. Just be sure to run the numbers, either on your own, with good real estate investment software, or with the help of a real estate professional.

Remember, real estate investing isn’t whimsy, its business. Best of all, real estate investment is profitable when done correctly.