In this real estate investing article, we want to discuss cash-on-cash return by exploring its meaning, benefits and shortcomings, popularity amongst real estate investors, and then the cash-on-cash formula alongside several examples.
So let’s get started.
The cash-on-cash return (or equity dividend rate) measures the ratio between a property’s anticipated first year’s cash flow before tax (CFBT) to the amount of initial cash investment made by the real estate investor to purchase the rental property.
Here’s the idea: cash on cash is the percentage of cash flow to cash investment.
The popularity and use of cash-on-cash in real estate investing is because it provides investors with an easy way to compare the profitability of several investment opportunities quickly. For example, an investor could compare the first-year yield of a real estate investment based on its cash-on-cash (or CoC) to the yield offered by a bank on a CD. In this case, for instance, the investor might decide to invest his same day cash advance cash into an apartment complex that returns a CoC of 7.6% rather than into a CD paying 3%, and vice versa.
Generally speaking, though, cash-on-cash return is not considered a particularly powerful tool for measuring an income property’s profitability because it doesn’t consider the time value of money. In other words, because it doesn’t compound or discount money over time, CoC is restricted to measuring an investment property’s cash flow in the first year of ownership only.
Nonetheless, the cash-on-cash return is not without validity. It certainly will provide real estate investors a quick way to compare investment opportunities and similar income-producing properties.
How to Calculate
Cash on Cash Return = Annual Cash Flow / Cash Investment
What It Means
Before we consider an example, let’s be sure we understand the components of the formula. This will be crucial for you to compute cash-on-cash correctly in your own rental property analysis.
1) Annual Cash Flow – This is the cash flow before tax (CFBT) in opposition to the cash flow after tax (CFAT). In other words, it’s the cash flow for the first-year without an adjustment for Federal income tax. CFBT is calculated by computing annual rental income less annual operating expense less annual debt service or loan payment.
2) Cash Investment – This is the total amount of initial cash required to purchase the property and includes the down payment, loan points, escrow and title fees, appraisal, and inspection costs.
Okay, let’s compute a cash-on-cash return.
You’re analyzing the profitability of a six-unit apartment building according to the following scenario. Each of the six units collects $1,000 per month. You estimate the first year’s operating expenses will be $28,800. Your mortgage requires $126,000 down, loan points of $2,940, and a monthly loan payment of $1,956. You estimate your closing costs, i.e., escrow, title, inspections, and appraisal fees, at $2,100.
First, compute the annual cash flow:
Gross Scheduled Income $72,000 ((6 units x $1,000) x 12)) less Operating Expenses of $28,800 equals $43,200 (Net Operating Income) less Mortgage Payment $23,472 ($1,956 x 12) = $19,728 Cash Flow
Next, compute your cash investment:
Down Payment of $126,000 plus Loan Points of $2,940 plus Closing Costs of $2,100 = $131,040 Cash Investment
Finally, compute CoC:
Cash on Cash Return = Annual Cash Flow / Cash Investment, or, $19,728 / $131,040 = 15.06%
Okay, now let’s apply it.
You’re trying to decide where to invest $126,000 cash. You can invest it in a 3% T-Bill at your local bank or, as you just discovered, you can purchase a six-unit rental income property and get a cash-on-cash return of 15.06%. What do you do next? You might want to do a full-blown real estate analysis on the property and look at some other key returns and measures. Though on the surface, the investment real estate appears to be the most prudent real estate investing choice, you can’t make a decision without more information and a more complete real estate analysis.