There are various aspects to consider while evaluating new investment properties. What are the initial and ongoing expenses? What kind of use does the property fit itself to? What type of profit do you think you can make?
Sifting through the figures and wading through a sea of terminologies like cap rate or internal rate of return (IRR) might be intimidating, but these tools are essential for the financial analysis you need to conduct before making a real estate investment. Another important metric? Cash-on-cash return.
What Is It?
The cash-on-cash return, also known as cash yield or the equity dividend rate, is a yearly measure of a real estate investor's earnings on a property in comparison to the cost the investor initially spent to purchase and make it operable.
If you're attempting to acquire an accurate picture of cash flow, this equation can help (in other words, comparing money in and money out). This is especially crucial if you have a variety of financing options and want to know how much money to put down and how much of a loan to take out.
It's a simple way to measure profitability when expressed as a percentage, so you may use it to make immediate comparisons when evaluating properties for investment.
Simply stated, your cash-on-cash return is the difference between your annual cash flow (pre-tax) and your total cash investment.
You want to total up your gross rent inflow for the year, as well as any other revenue you might get from the property, such as additional rent for parking spaces or storage units, to determine your pre-tax cash flow for the year. To calculate your net operating income, deduct your operational expenses ( handyman, property manager, gardener, plumber, and other regular care) from your annual mortgage payments if you have one.
Furthermore, you must multiply this number by the whole amount of money you put into the property at the start, which is your total cash invested. This could include your down payment (or the entire purchase price if you paid cash), closing costs, and any maintenance or upgrades you completed before the property could be rented. Your cash-on-cash return is calculated as a percentage of the result.
As long as your income from the property and your investment in it stays constant, your cash-on-cash return should be roughly consistent. If your revenue rises as a result of being able to charge higher rent, your cash-on-cash return can rise as well.
Taxes and Cash-on-Cash
In the cash-on-cash computation, the tax refers to the investor's individual tax position. Regardless of who owns an investment property, the cost of capital is the same, but the amount of income tax paid varies from investor to investor. By excluding tax from the equation, it becomes easier to compare different real estate investment returns on an apples-to-apples basis (and investors).
Cash-on-Cash Return vs. ROI
The cash-on-cash return statistic differs from ROI in that ROI is concerned with overall profitability (the amount of total gain or loss the property generates) over the course of ownership, whereas cash-on-cash is a brief overview of annual cash flow. Return on investment (ROI) is cumulative, whereas cash-on-cash is not. This also considers all of a property's debt, whereas cash-on-cash simply considers the money you pay right now.
In practice, ROI can be estimated using your property's fair market value, but it can only be really assessed when you sell it.
Cash-on-Cash vs. Cash Flow
Cash-on-cash return differs from cash flow in two aspects:
Firstly, cash-on-cash is calculated as a percentage, whereas cash flow is expressed as an amount.
Secondly, once all of your expenses have been paid, cash flow shows you how much money you should have left to deposit into your bank account at the end of the day (except income tax). The term "cash-on-cash" refers to the rate of return on the entire amount of cash invested (acquisition equity plus subsequent equity infusions).
Here's another way to think about the difference between cash-on-cash return and cash flow. Assume you put the same $100,000 into a CD. According to BankRate.com, the current rate is at 2.7 percent, which means you get $2,700 per year. Thus, your annual cash flow is $2,700, and your cash-on-cash return is 2.7 percent (which isn't great).
Internal Rate of Return
The total interest earned on cash invested is defined as the IRR. Internal Rate of Return is another real estate valuation measure to consider (IRR). The key difference between it and the cash-on-cash return is that cash-on-cash evaluates earnings in annual segments, whereas IRR calculates total earnings throughout the full ownership cycle.
Assume you intend to keep your rental property for the next 10 years. Because it earns interest over nine years instead of one, the rental money you receive in the first year of ownership earns higher interest than the rental money you receive in the last year of ownership.
The IRR method, which is best done with tools like Microsoft Excel, takes a comprehensive look at how rent and appreciation income rise over time to forecast a property's overall value.
Cash-on-Cash Return Rates
It's difficult to quantify the concept of a good cash-on-cash return because it's so subjective. While eight to 12 percent is a good round number, different types of investments offer varied rates of return, which can, of course, rely on you as an investor.
The bottom figure in the equation can be substantially greater if you buy a property with cash. If you have a monthly mortgage payment to make, that top amount may be smaller. As a result, the cash-on-cash return rate can be a useful indicator for evaluating multiple possible properties or determining how much to invest upfront or how much to borrow.
Cash-on-Cash Return Matters
This cash-on-cash return formula is used by most real estate investors as the first step in their buying decision, and for good reason. Cash-on-cash returns can provide answers to a variety of important concerns about how to proceed with a sale.
It can assist you with:
Tally Expenses: The cash-on-cash formula urges investors to consider the obvious (and not so obvious) expenses that should be associated with the rental property early on.
Selecting the Best Property: It gives investors a simple and efficient way to compare the long-term profitability of numerous rental properties at once, allowing them to pick the one with the best potential return.
Decide on Financing: Buying cash-on-cash also answers important questions about financing, such as whether to take out a mortgage and how much to borrow, or whether an all-cash buy is the better option.
The cash-on-cash return ratio is mostly used to determine one year's earnings, but it can also be used to estimate future profits. You can forecast your returns ahead of time if you know your property's rents should increase by a particular percentage five years from now, or if you know a major repair, such as a roof or cooling system that may be needed at some point. This is why re-running the formula every year is a smart idea.
Tax benefits and return on investment are two elements that a cash-on-cash return cannot account for. As an example, return on investment cannot be computed until the property is sold.
Consequently, you want the cash-on-cash formula to be just one of the numerous property valuation methods you use for your study in order to make the safest, most informed decision possible.
When to Calculate Cash-on-Cash Return
Cash-on-cash returns are used by a large portion of the real estate market, including investors and agents. Why? Because of the metric's ease of usage. This percentage should be calculated during the following times.
1. If you’re determining how much financing to use
This statistic refers to the rate of return on the cash invested. It solely takes into account returns that are driven by the property's net cash flow and ignores asset appreciation.
Because cash-on-cash return compares net cash to real cash spent, it's an excellent tool to examine the impact of leverage and compare different levels of financing. Your cash-on-cash return can be lower if you use leverage.
2. If you’re looking for a simple rule of thumb
It's simple to figure out how to calculate cash-on-cash returns. Because of its simplicity, the computation takes only 10 minutes or less to complete, and it often yields a return on equity that is within two to five percent of the actual return.
The cash-on-cash return can help you gain a sense of the potential of your property, but it is constrained in a few key respects. This computation disregards your specific tax status and does not account for appreciation or depreciation. It can't tell you what should happen if there's a fire or a flood, or what long-term expenditures you can have, or how much money can get when you sell the property.
At the end of the day, a cash-on-cash return can tell you how much money you may have this year, but it cannot tell you how much money you may have next year.