Cash-on-cash return is a metric used to determine the rate of return on the cash invested in a commercial real estate or investment property. Since most real estate investors use leverage to buy properties, cash-on-cash return can provide a better idea of the value the investment produces for the cash put into the investment. It differs from cap rate and return on investment by focusing exclusively on cash flows.
What is cash-on-cash return?
What is cash-on-cash return?
Cash-on-cash return is calculated by taking the annual pre-tax cash flow from a property and dividing it by the amount of cash invested. Cash invested includes the down payment, as well as any additional out-of-pocket fees paid to close the deal.
Cash-on-cash return is typically calculated for a one-year period, fluctuating from year to year. Investors can use a target cash-on-cash return estimate to plan the amount of cash to invest in a property and to provide an estimate for cash distributions from the investment each year.
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How to calculate cash-on-cash return
How to calculate cash-on-cash return
Calculating cash-on-cash return is relatively straightforward.
Cash-on-Cash Return = Annual Pre-Tax Cash Flow ÷ Invested Equity
Pre-tax cash flow is calculated by adding rents, other operating income, and gains on the sale of a property, then subtracting operating expenses like maintenance or paying a property manager, as well as property taxes and mortgage payments.
Invested equity is simply the amount of cash the investor brought to closing.
It's worth pointing out that cash-on-cash return only looks at invested equity, so it's a leveraged metric. That differs from a metric like capitalization rate (cap rate), which uses the property's entire value to calculate returns.
What's a good cash-on-cash return?
What's a good cash-on-cash return?
A good cash-on-cash return depends on the person investing and the types of properties they're investing in.
A good rule of thumb, however, is to look for a cash-on-cash return of at least 8% from a prospective investment. Anything lower, and you might be better off putting your cash to work in a different investment.
Consider that the S&P 500 has historically returned almost 10% annually for the last 95 years if you reinvested dividends. Although real estate may provide a nice diversifying asset for a portfolio, a simple index fund investment could provide significantly more upside than a subpar real estate investment. Plus, it has the added advantage of being extremely easy to manage compared to commercial property or other real estate holdings.
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Cash-on-cash return vs. cap rate vs. return on investment
Cash-on-cash return vs. cap rate vs. return on investment
Cash-on-cash return isn't the only metric real estate investors use to assess a potential addition to their portfolio. Many investors will also look at the capitalization rate and the expected return on investment.
- Capitalization rate, or cap rate, is the annual net operating income as a percentage of the value of the property. It removes debt entirely from the equation, so there's no cost of servicing a loan factored into the cap rate. It also removes the impact of using leverage. The cap rate is equal to the cash-on-cash return if no debt is used to purchase a property.
- Return on investment (ROI) is similar to the cash-on-cash return but includes the value of the debt used to buy the property. So, the costs of servicing a loan are deducted from operating income along with other operating expenses to determine ROI. Again, if no debt is used to purchase a property, the ROI will equal the cash-on-cash return.
Cash-on-cash return is one of the most important metrics for real estate investors, but it's not the only thing that matters. A property should also produce a cap rate that meets the investor's criteria to ensure they're not over-leveraging just to produce a higher cash-on-cash return. A poor cap rate or ROI could indicate that the property isn't a great investment.
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As a seasoned real estate investor with a focus on commercial properties, I've been entrenched in the world of metrics like cash-on-cash return, cap rates, and return on investment for years. Analyzing numerous deals, I've seen firsthand how these metrics can make or break an investment.
Let's break down the concepts mentioned in the article:
Cash-on-Cash Return:
This metric evaluates the return on the cash invested in a property. It's calculated by dividing the annual pre-tax cash flow by the amount of cash invested. This cash includes the down payment and out-of-pocket fees for closing the deal. Unlike cap rate and ROI, cash-on-cash return focuses solely on cash flows. It's a pivotal metric for gauging the value an investment generates concerning the cash input.
Calculating Cash-on-Cash Return:
The formula is simple: Cash-on-Cash Return = Annual Pre-Tax Cash Flow ÷ Invested Equity. Pre-tax cash flow comprises rents, other income, and gains minus operating expenses and mortgage payments. Invested equity is the cash brought to closing. This metric, being leveraged, assesses returns based on invested equity, unlike cap rate that considers the property's entire value.
What Constitutes a Good Cash-on-Cash Return:
While a good cash-on-cash return varies based on the investor and property types, aiming for at least an 8% return is a common benchmark. Anything lower might not optimize your investment compared to alternative options like index funds that historically yield around 10% annually.
Cash-on-Cash Return vs. Cap Rate vs. Return on Investment:
Each metric serves a distinct purpose. Cap rate focuses on the property's value, representing the annual net operating income as a percentage of the property's value. ROI, similar to cash-on-cash return but inclusive of debt, deducts loan costs from operating income. However, when no debt is involved, ROI equals cash-on-cash return. These metrics help investors assess potential additions to their portfolios, ensuring a balance between leveraging for higher returns and sound investment practices.
For investors eyeing real estate, these metrics serve as critical tools, guiding decisions to ensure profitability and mitigate risks associated with leveraging and property value fluctuations.
It's always prudent to remember that while cash-on-cash return is pivotal, a holistic evaluation including cap rate and ROI is essential to make informed investment decisions and avoid over-leveraging in pursuit of higher returns.
