What does Cash-on-Cash Returns mean for Real Estate Investors?

If you’re a rental property investor in New Bern area who’d like to measure the profitability of a real estate deal, you may have run into some difficulty finding a metric that best suits your needs. For instance, return on investment (ROI) measures returns as a function of appreciation or equity, which can be tricky to apply to rental properties.

As a result, you should familiarize yourself with the concept of cash-on-cash return, otherwise known as a metric, to measure profitability.

What Is Cash-on-Cash Return?

Cash-on-cash return is one of several metrics used by real estate investors to evaluate an investment property’s current or future profitability. The calculation measures the net income produced by a property relative to the initial cash investment made to purchase that same property. In other words, cash on cash return tells you how much of your out-of-pocket investment you’re earning back each year.

Why Is It Important?

Cash on cash returns are important when evaluating the potential profitability of a deal. This formula can be a great way to determine how an investment will perform and ultimately help you determine whether to invest. Cash on cash returns can also point investors to the right financing method — for example, if you are torn between a traditional mortgage or private lender. The cash-on-cash returns formula might reveal which route allows you to maximize your annual returns.

Many investors use cash on cash returns to compare different investment properties as well. By looking at this metric across different properties, investors can better understand how each one will impact their overall portfolios. By relying on cash-on-cash returns as a comparison, investors can get a consistent look at the long-term potential of multiple assets.

How To Calculate Cash on Cash Return

The formula for calculating cash on cash return is as follows:

• Mortgage
• Property taxes and insurance
• Maintenance costs
• Utilities
• Property management fees
• Vacancy rate
• HOA fees (if applicable)

Preparing an itemized list of your monthly rental income and expenses is the most efficient way to calculate your return. This allows you to calculate your monthly and annual cash flow, which are numbers you need to know before you can use the equation. If you are using this formula as a part of your deal analysis, you will need to project your numbers as best as you can. If you need some help with this step, here is a resource on accurately estimating your rental property expenses.

Once you have these numbers, go through the following steps to find out your return:

1. Calculate your monthly cash flow: Using the list you prepared earlier, subtract your expenses from your income. Don’t forget to include other sources of income aside from rent, such as pet deposits or laundry fees. For example, let us say that you earn $1,500 per month in rent, but you pay $1,200 in expenses, including your mortgage. This leaves you with $300 in net cash flow each month.
2. Convert to annual cash flow: Once you have your monthly cash flow, multiply the amount by 12 to arrive at your annual cash flow. Continuing with our example above, your annual cash flow is $3,600 ($300 per month x 12 months).
3. Add up your initial cash investments: Next, add up any cash you paid out-of-pocket when initially acquiring the property. This might include the down payment, closing costs, and any improvements or repairs made to the property before you had any tenants. Let us say you acquired a rental property for $300,000. You took out a mortgage to finance the purchase but put down a 20 percent down payment of $60,000, plus $8,000 in closing costs out of pocket. Also, you invested about $2,000 of your own funds to make some repairs. This means that your initial cash outlay totaled $70,000.
4. Divide your annual cash flow by your initial cash investment: Once you have your annual cash flow and initial cash investment totals, you are now ready to calculate your cash on cash return. Take your annual cash flow and divide it by your initial cash investment. From our example, your annual cash flow is $3,600, which you divide by your initial cash investment of $70,000. Your resulting return should be roughly 0.0514.
5. Multiply the resulting fraction by 100%: Because decimals can be difficult to work with, you can convert this figure into a percentage by multiplying it by 100%. The cash on cash return from the example above can be converted to 5.14% (0.0514 x 100%).
6. Analyze your results: Finally, it’s important to think about what your calculation means. In the example, you calculated a 5.14% return. This means that in one year, you will have earned back just over 5 percent of the initial cash investment you made, which was $70,000.

Cash-on-Cash Vs. ROI

Although you might hear investors use the terms cash on cash return (CCR) and return on investment (ROI) interchangeably, they are not the same. While cash on cash looks at returns relative to any cash spent out of pocket, ROI looks at returns on the total investment, including loans you took to finance the purchase. As mentioned earlier, calculating ROI for a rental property can get a little tricky, as it typically measures the returns based on the eventual sale price of a property. However, there are ways to get around calculating ROI on a rental property, explained in detail here.

Cash-on-Cash Return Vs. NOI

NOI, or net operating income, is calculated differently than cash on cash return. The main difference is that cash on cash return takes debt services into account, while NOI does not. You can find your projected NOI by property operating expenses from the total income a property will generate when completely leased out. Operating expenses include landscaping, utilities, and maintenance.

Cash-on-Cash Return Vs. IRR

Internal Rate of Return, called IRR, is used to determine the potential profitability of an investment by analyzing the entire holding period. IRR calculations are determined using total cash flow, initial investment costs, and the potential holding period. Cash on cash return, on the other hand, focuses on profitability only in relation to the initial investment. Cash on cash return does not take into account the entire ownership period of the investment.

What is a Good Cash-on-Cash Return?

There is no specific rule of thumb for those wondering what constitutes a good return rate. There seems to be a consensus amongst investors that a projected cash on cash return between 8 to 12 percent indicates a worthwhile investment. In contrast, others argue that even 5 to 7 percent is acceptable in some markets. A beginner investor might start with a lower cash on cash return requirement and increase their standards as they gain experience and know exactly what to look for in a rental property.

Another factor to consider when looking at your return is what your investment objectives are. For example, if you invest in a growing or appreciating market, you may have a lower return; but that does not necessarily make it a poor investment.

It’s important to note that your return rate will vary greatly based on how much you spend out-of-pocket and how your cash flow is structured. For example, if you invest zero dollars of your own funds, your cash-on-cash return would be zero. This doesn’t mean that you have a bad investment on your hands, but the formula is not helpful in this specific case. This shows that understanding how a formula works and what the numbers mean is just as important as the results. It also demonstrates why investors use several different formulas to conduct their deal analyses.

Check Cash-on-Cash Annually

Cash on cash returns are most commonly used when analyzing a potential deal — but that doesn’t mean you can’t keep this formula in your toolkit. Cash-on-cash returns can come in handy as rent prices fluctuate, so you can continue evaluating your investments. For example, if you evaluate a property where a rental increase is expected in the next two years, it can be good to run those numbers. Cash on cash returns can help you gauge the performance of your investments.

Remember that this formula is only one of several metrics you should be using to evaluate rental properties. There are certain shortcomings in regards to tax benefits and return on investment (ROI). However, it can still be useful each year as you compare investments, evaluate existing properties, and consider new real estate deals. Always keep this formula in mind as you continue to grow your investment portfolio.

Summary

If you weren’t familiar with the cash-on-cash return formula before, you might find yourself using it frequently moving forward. Not only does it allow you to measure returns as a function of your cash flow, but it can also help you decide if a potential deal is viable or how much to put towards a down payment. However, make sure that it’s not the only formula that you rely on. The most successful investors use not one but several metrics to analyze deals.