What is cash-on-cash return in real estate?
What is Cash-on-Cash Return in Real Estate?
Cash-on-cash return is a metric used in real estate investments to calculate the return on the actual cash invested in a property.
This calculation is particularly relevant for investments where financing (like a mortgage) is used, as it focuses on the investor's out-of-pocket expenses rather than the total purchase price of the property. It represents the annual return an investor makes on a property relative to the amount of cash invested, and is expressed as a percentage. The formula for calculating cash-on-cash return is:
Cash-on-Cash Return = Annual Pre-Tax Cash Flow / Total Cash Invested × 100%
Components of Cash-on-Cash Return
- Annual Pre-Tax Cash Flow: This is the net income the property generates in a year, typically calculated as the gross rental income minus all expenses (like mortgage payments, property management fees, maintenance, property taxes, insurance, and any other expenses).
- Total Cash Invested: This is the total amount of cash the investor personally invested into the property. It includes the down payment, closing costs, renovation costs, and any other out-of-pocket expenses to acquire and prepare the property for rental.
Cash-on-Cash Return Example
If an investor puts a $50,000 down payment on a rental property and spends an additional $10,000 on closing costs and renovations, their total cash invested is $60,000. If the property then generates $6,000 a year in net income (after expenses), the cash-on-cash return would be:
Cash-on-Cash Return = $6,000 / $60,000 × 100% = 10%
Why Calculate Cash-on-Cash Return?
- For Real Estate Investment Analysis: Cash-on-cash return provides a quick snapshot of the investment’s profitability and cash flow.
- As a Tool for Comparison: It allows investors to compare the performance of different properties.
- To Measure the Impact of Leverage: It helps investors understand the impact of leverage (borrowed money) on their investment returns. Negative leverage actually reduces cash-on-cash returns, so it is important to measure for every deal.
Some Limitations of Cash-on-Cash Return as a Return Metric
- Does Not Account for Appreciation: It only measures the return on the cash flow and does not include the potential increase in the property's value over time.
- No Tax Consideration: It doesn’t take into account the tax implications of the property investment.
- Annual Measure: It's based on a single year’s performance, which might not be representative of the property’s long-term performance.
Cash-on-cash return is a valuable metric for real estate investors, especially when used in conjunction with other financial measures like Internal Rate of Return (IRR), Net Operating Income (NOI), and Cap Rate to gain a comprehensive understanding of an investment’s potential.