When it comes to real estate investing, experienced investors know howto talk the talk. One of the most important things they talk about? "Cash on cash return".
This post will walk you through what cash on cash return is, why it’s so important, and how to calculate it. We'll even provide a real-world example to help illustrate the concept for those new to investing.
By the end of this article, you should have a solid understanding of what cash on cash return is, and why measuring it can help you make more informed decisions in your real estate investments.
What Is Cash On Cash Return?
Cash on cash return is a metric used by real estate investors to evaluate the performance of their investments. It's essential to understand because it measures the annual pre-tax cash flow that an investment property generates compared to the initial amount of cash invested.
Put another way, cash on cash return calculates the return on investment (ROI) based solely on the cash invested, rather than the total value of the property. This makes it an excellent way to assess the cash flow efficiency of an investment, particularly for investors who rely on rental income to cover their expenses.
Why You Should Care About Cash On Cash Return
For real estate investors, cash flow is often a crucial consideration when evaluating potential properties. This is because rental income can help cover the expenses associated with owning and maintaining the property, such as mortgage payments, property taxes, and maintenance costs. Therefore, understanding the cash on cash return is important for several reasons:
Comparing investments: Cash on cash return allows investors to compare the performance of different investment properties on an equal footing, regardless of the size or value of the properties. This can help identify which properties offer the best return on investment.
Assessing leverage: By calculating the cash on cash return, investors can determine how much leverage (debt) they can safely use to finance their investment without jeopardizing their cash flow.
Evaluating cash flow efficiency: A high cash on cash return indicates that a property generates a significant amount of cash flow relative to the initial cash investment, which can be especially important for investors who rely on rental income to cover their expenses.
How To Calculate Cash On Cash Return
Calculating cash on cash return is relatively simple. First, you'll need to determine the annual pre-tax cash flow for the property. This is calculated by taking the annual rental income and subtracting all property-related expenses (excluding mortgage principal payments, as these are not considered an expense for this calculation). Then, divide the annual pre-tax cash flow by the initial cash investment to determine the cash on cash return.
Cash on Cash Return = (Annual Pre-Tax Cash Flow / Initial Cash Investment) x 100
Keep in mind that the initial cash investment includes the down payment, closing costs, and any initial repair or renovation costs.
A Real-World Example Of Cash On Cash Return
To better understand the concept of cash on cash return, let's consider a real-world example. Suppose you're considering investing in a rental property that costs $200,000. You plan to make a 20% down payment ($40,000) and incur $5,000 in closing costs. Additionally, the property requires $5,000 in repairs and renovations before it can be rented out.
In this scenario, your all-in initial cash investment is $50,000 ($40,000 + $5,000 + $5,000). For simplicity’s sake, we’ll assume that after you’ve made the necessary repairs and renovations, the property rents for $1,500 per month, or $18,000 per year.
Your annual property-related expenses (excluding mortgage principal payments) amount to $6,000, which includes property taxes, insurance, and maintenance costs.
To calculate the annual pre-tax cash flow, subtract the annual expenses from the annual rental income:
Annual Pre-Tax Cash Flow = $18,000 - $6,000 = $12,000
Now that we have the annual pre-tax cash flow, we can calculate the cash on cash return:
Cash on Cash Return = ($12,000 / $50,000) x 100 = 24%
In this example, the cash on cash return is 24%, which means that for every dollar you invested initially, you can expect to receive a pre-tax return of 24 cents per year. This helps you understand the cash flow efficiency of this particular investment, and you can use this metric to compare it with other potential investments.
Limitations and Considerations
While cash on cash return is a valuable metric for real estate investors, it's essential to understand its limitations and consider other factors when evaluating a property. Some limitations and considerations include:
Pre-tax calculation: Cash on cash return is calculated using pre-tax cash flow, which means it doesn't account for the investor's individual tax situation. Different investors may have varying tax liabilities, which can impact their actual returns.
Narrow focus: Cash on cash return focuses solely on cash flow and doesn't consider other factors such as property appreciation, potential tax benefits, or principal paydown on the mortgage. It's essential to consider these aspects when evaluating a property's overall return on investment.
Short-term perspective: Cash on cash return is typically calculated on an annual basis, which means it may not capture the long-term performance of an investment property. Investors should also consider long-term metrics such as internal rate of return (IRR) or total return on investment to get a more comprehensive picture of a property's performance.
Understanding cash on cash is one of the many concepts you need to master as a real estate investor. And for more tips and tricks on real estate investing, make sure to check out Leadflow’s real estate investing fundamentals and learning resources below!