WHAT IS CASH ON CASH RETURN AND WHO SHOULD USE IT
The whole purpose of investing in real estate is to realize a good return on your investment (ROI). There are various metrics to determine the results, yield on cost, internal rate of return (IRR) , cash on cash return (CoC) and others. Today we are going to discuss Cash on Cash return and why it is one of the more favored calculations.
WHAT IS CASH ON CASH RETURN?
Cash on cash return is a metric most commonly used by real estate investors to measure the annual cash flow of a property against the amount of the initial cash investment. It is a fairly simple and straightforward calculation that can help an investor determine the rate of return they earned or could have earned on a property or a prospective property in a given year.
The formula is among the most used in the real estate investing world because, in addition to its simplicity, it also factors in how borrowed funds impact cash flow. It is also sometimes known as the cash yield on investment property.
As mentioned above, determining the cash on cash return of a property is fairly simple. The two components needed to perform the calculation are the cash flow of the property and the initial out of pocket costs on the property.
Let’s take a closer look at what is included in each of these components.
HOW TO CALCULATE CASH ON CASH RETURN
To determine the cash on cash return, you must first know how much cash flow has been received as well as how much you put into the property initially.
The calculation looks like this:
DETERMINING CASH FLOW
Your net operating income (NOI) is what determines your cash flow. To calculate your NOI you will need to know your gross rents as well as other income producing factors as well as your operating expenses.
Other income factors may include the following:
- Pet rents
- Coins from laundry machines
- Late fees
- Storage fees
- Parking fees
- Other income
Operating expenses typically include:
- Debt service
- Actual vacancy
- Insurance costs
- Maintenance fees
- Management fees
- Marketing costs
- Other operating expenses
Once you have all of these figures, then add up all of your income and then subtract your total operating expenses. The result is your cash flow.
Now for the second part of your equation, let’s move on to calculating your initial cash expenses.
CALCULATING INITIAL CASH EXPENSES
Your initial cash expenses, or out-of-pocket costs, typically include your down payment, closing costs and pre-rental improvements and repairs. In other words just the repairs and improvements necessary to get it rent ready – not later repairs.
Your initial out of pocket expenses also do not include the debt associated with the property (your monthly debt service payments ARE taken into account in determining your cash flow).
WHAT IS A GOOD CASH ON CASH RETURN?
While there is no set percentage that has been deemed a “good” cash on cash return, the consensus among investors seems to be between 8% and 12%, while others may argue that 5% to 7% is a better estimate, depending on the market. When considering the long term gains in the stock market average of 8%, these estimates fair pretty well.
WHEN SHOULD I USE CASH ON CASH RETURN?
Due to its simplicity, cash on cash return is widely used by both agents and real estate investors. Here are a few of the reasons you should use cash on cash return.
Several other calculations may provide a much better overall picture on the return of a property; however, they are also much more involved.
For the new or less sophisticated investor it is a tool that can be learned and used quickly.
For a busy investor analyzing many deals a week, being able to have a quick way to assess the viability of a potential property saves a lot of time.
THE NEED FOR CONSISTENT CASH FLOW
Every investor has a different goal in mind. Some are looking for overall appreciation on a property while others are most concerned about consistent cash flow.
In terms of the latter, cash on cash return is the favored metric because inherent in the calculation you have determined the cash flow or potential cash flow of a property.
As an example, Investor A may be fine with a 3% cash on cash return, because the property is in a coastal city that sees consistent appreciation, lack of inventory, and the owner intends to hold the investment for a period of time to use at a later date to fund their retirement goals. Their rate of return considering appreciation works out to be 20% or more.
On the other hand, Investor B has properties in a part of the county that has averaged about a 1% rate of appreciation in the last 20 years, but rents are good and outpace appreciation. Investor B is looking to rely upon a monthly cash flow to provide a reliable source of income indefinitely. Obviously, in this instance cash flow is more important than appreciation.
USING CASH ON CASH RETURN TO ASSESS THE BENEFITS OF LEVERAGE
Leverage reduces the cash on cash return. That’s why using cash on cash return is a good metric; it measures the actual cash flow (deducting loan payments) against the initial cash invested. It is a good way to evaluate the effect of leverage to use on a property.
COMPARING MULTIPLE INVESTMENTS
Because cash on cash return provides you with the current yield on your investment, it is also a great metric to compare against other types of investments, like stocks and bonds. It does not measure risk – so that is always something to keep in mind.
WHAT ARE THE PROS AND CONS OF USING CASH ON CASH RETURN?
PROS OF THE CASH ON CASH RETURN METHOD
- Ease of use
- Able to compare other properties
- Able to compare property(s) against other investment types
- Great indicator of the impact of leverage
- Provides a snapshot of immediate returns
- Insight into ongoing cash flow (passive income)
- Gives a good picture of the current yield
CONS OF THE CASH ON CASH RETURN METHOD
- Does not factor appreciation
- Does not factor tax benefits
- Does not consider the risk inherent in debt
- Not a good metric for long term investments (IRR best for longer term investments)
- Does not figure your actual Return on Investment
- Does not account for the time value of money or compound interest
- Does not figure ongoing pay down of debt (equity), value of improvements or repairs
- Underreports the potential profits
CASH ON CASH RETURN VS. OTHER METRICS
As mentioned above, one CON of the cash on cash method is that it does not figure an investment’s actual return.
And while cash on cash return is a useful metric to evaluate or project a property’s performance, it is not the best metric for longer terms. For longer terms, other methods are more accurate.
CASH ON CASH (CoC) VS. ROI (ROI)
The major difference between CoC vs. ROI is that CoC looks at the current income relative to the cash invested at a point in time, whereas ROI looks at the overall return once an investment has completed its life cycle (i.e. when it is sold/expected sale data).
CASH ON CASH VS. INTERNAL RATE OF RETURN
Internal Rate of Return is a more complicated formula that is difficult to determine without a calculator or software. It is best used when your investment has uneven cash flows, is a depreciating asset or when you want the real time yield over the total time the property is held.
A major way IRR differentiates itself from other calculations is that it measures the annual growth rate, which becomes more important the longer the investment is held.
We hope you have found this information useful. If you are interested in seeing how we fared our first year as real estate investors, using the cash on cash return as our metric, check out our video we did about it.