There are several complex metrics that real estate investors often use to evaluate potential deals, such as internal rate of return, capitalization (cap) rate, and more. One of the simpler metrics to know is cash-on-cash return, which can be an extremely important piece of the puzzle for income investors.
With that in mind, here’s a primer on how cash-on-cash return works, the shortcomings of the metric that you should be aware of, and how to use it in your property analysis.
What is cash-on-cash return and how do you calculate it?
Cash-on-cash return tells you the return on your investment relative to the amount of cash that you’re paying to acquire it.
The calculation is simple. Just divide the property’s annual before-tax cash flow by the total cash you invest in the property. For example, if you expect to generate $10,000 of cash flow from a property that cost you $100,000 out-of-pocket to acquire, your cash-on-cash return is 10%.
To be perfectly clear, the $100,000 in this example doesn’t refer to the purchase price. This is the actual amount of cash you spent to acquire it. For example, this could mean that you put $80,000 down on the mortgage, paid $10,000 in legal expenses, and spent $10,000 on property improvements.
Why is this important for real estate investors to understand?
Cash-on-cash return can be a great way to compare real estate investment opportunities with different acquisition costs and different financing structures. As a simplified example, consider these two hypothetical real estate deals:
- A single-family rental property for $100,000 that needs $10,000 in repairs that rents for $1,100 per month. You expect that your monthly cash flow will be about $600 after all expenses and vacancy/maintenance reserves. However, it’s in rough shape and the seller insists on an as-is sale, so it must be an all-cash purchase.
- A duplex in great shape selling for $150,000 that generates $1,400 in monthly rent. However, because it’s in great shape, a lender only wants 20% down to finance the property ($30,000). After paying all of the expenses, including the mortgage, you estimate $300 in monthly cash flow from the property.
Obviously, the first property will generate more cash flow -- $7,200 per year versus $3,600 from the duplex. However, you’re laying out $110,000 in cash to acquire the single-family home, as opposed to just $30,000 to acquire the duplex. This translates to a 6.5% cash-on-cash return for the first property and a 12% cash-on-cash return for the duplex.
Shortcomings of cash-on-cash return calculations
As I mentioned, this is a simplified example, but this does give a good idea of how cash-on-cash return works. Having said that, it’s important for investors to realize that cash-on-cash return isn’t a perfect metric by any means and has a few major shortcomings.
For starters, cash-on-cash return doesn’t account for increases in the property’s value. In other words, real estate investments make money in two main ways -- income and equity appreciation. Cash-on-cash return only looks at income, and it’s entirely possible for a property with poor cash flow to produce excellent returns because of an increase in its market value. Furthermore, many investment properties are purchased with the intention of making value-adding repairs and it’s not uncommon for a property in need of repairs to be worth significantly more after repairs are made.
Also, cash-on-cash return doesn’t take risks into account. In the example in the previous section, the all-cash deal is likely to be safer than the highly leveraged purchase. Be sure to account for any increased risks as well when comparing cash-on-cash returns.
Finally, remember that cash-on-cash returns are based on before-tax cash flows. Real estate taxes can be quite complicated, and the taxable portion of your rental income can vary significantly from one property to another.
A valuable part of your analytical toolbox
Like most financial metrics, cash-on-cash return is best used in combination with other metrics as well as qualitative factors when comparing prospective real estate investments. All things being equal, it’s obviously better to have a higher cash-on-cash return, but it’s important to consider the entire picture before making a decision.