Cash-on-Cash Return for Analyzing Real Estate Investments
The cash-on-cash return is one of the most commonly used metrics for analyzing real estate investments.
Due to its popularity, many real estate investors believe cash-on-cash return is a sufficient indicator to rely on for analyzing real estate investments, and some of them might base their investment decisions solely on this metric. This, however, is a huge mistake in real estate investing. The cash-on-cash return is one of many metrics used for analyzing real estate investments.
There are certain situations where the cash-on-cash return should be used. In order to understand when it is the right time to use this metric, it is important to deeply understand the cash-on-cash return and its uses in order to be able to use it for analyzing real estate investments.
How to Calculate Cash-on-Cash Return
The cash-on-cash return metric is used to calculate the amount of cash that a real estate investment will make as a percentage of the total amount of cash invested. To calculate cash-on-cash return, real estate investors need to determine the before-tax cash flow of the investment property in a given period and divide that value by the equity invested in the investment property by the end of that period.
The formula for calculating cash-on-cash return is fairly simple, and any real estate investor should be able to calculate it on his/her own.
Cash-on-Cash Return = (NOI/Cash Invested) x 100
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The value you get is the amount of cash that the investment property generates as a percentage of the total equity invested in the property in a given year. So, a 20% CoC return means that each year the investment property generates cash that is equal to 20% of the total equity invested, and in 5 years the investment property will have generated enough cash to make up for all the cash invested in it by the real estate investor.
Examples on Calculating Cash-on-Cash Return
To better understand the cash-on-cash return metric and its use for analyzing real estate investments, let’s take a look at a few examples where the cash-on-cash return can be useful.
Example #1:
A real estate investor buys a property for $200,000. He/she puts an additional $40,000 in repairs and renovation, and an additional $20,000 in carrying and closing costs. This means that the real estate investor has put a total of $260,000 into the investment. In this case, if the investor decides to sell the investment property for $300,000, he/she would be making a total profit of $40,000.
That is a return of 15.38%.
Example #2:
Let’s say that a real estate investor does the same deal but uses a mortgage to finance the purchase of the investment property. The investor borrows $200,000 from a lender and pays an additional $10,000 in interest. The total cost of this investment would be $270,000, and the profit is $30,000. But since the real estate investor only paid $70,000 (interest + other costs) in cash, the cash-on-cash return for this investment would only take that amount into account:
$30,000/$70,000 = 42.85%
Example #3:
This time, we will use the same investment property as the other examples, but we’re using a rental property instead. The real estate investor is purchasing the property for $260,000 total costs, and he/she’s financing 75% of the purchase using borrowed money. This means that the loan amount is $195,000, and the amount of cash that the real estate investor is investing is $65,000. This real estate investor decides to rent out the property to a tenant.
Let’s suppose that the rent of the property is $4,000, and the total running costs and expenses are $3,000. This means that the real estate investor is generating a positive cash flow of $1,000 per month, or $12,000 per year.
The cash-on-cash return calculation would be like this:
$12,000/$65,000 = 18.46%
Cash-on-Cash Return vs. Return on Investment
The cash-on-cash return is different from the ROI in that it does not take into account certain aspects of an investment such as the amount of money that will be recovered when the investment property is sold. For instance, in the examples above, the cash flow that was used for the calculation was the rent minus the expenses. The expenses in this situation included running expenses as well as the PITI (principal, interest, tax, and insurance) costs.
Upon selling the investment property, part of that PITI will be recovered. But the cash-on-cash return does not take that into consideration. It only measures that amount of money that you make as a profit compared to the amount of money that you’ve invested. This makes the CoC much easier to calculate than the ROI.
The return on investment is typically more difficult to calculate as it takes into account the cash flow, tax benefits and deductions, equity, and appreciation. Some of these values will only be relevant after refinancing or selling the property.
This, however, means that any appreciation or equity on top of the cash-on-cash return is a bonus value.
When to Use the Cash-on-Cash Return Metric
There are cases when the cash-on-cash return is an especially useful metric to rely on when analyzing real estate investments. The main use of the cash-on-cash return when analyzing real estate investments is knowing that you have a consistent positive cash flow during operation.
Here are some cases where the cash-on-cash return metric is useful:
- A real estate investor wants to invest $600,000 in the purchase of a long-term investment property. The investor wants to use the rental income from the property to cover his/her living costs, for which he/she needs a minimum of $45,000 before-tax income. For this, the real estate investor needs only to target an investment property that has a minimum of 7.5% CoC return to be able to cover the living costs from this investment.
- A real estate private equity firm is raising capital to invest in real estate. The four prospective investors request a quarterly cash flow distribution of at least 1.5% of the invested capital. Additionally, the fund charges each investor 80bps, or 0.80% annually. To meet the requirements, the managers of the fund will have to seek an investment property that has a minimum annual cash-on-cash return of 6.80% (1.5% x 4 + 0.80%).
When Not to Use the Cash-on-Cash Return Metric
There are also situations where the cash-on-cash return is not a good metric to rely on, and where other metrics might be more useful for analyzing real estate investments.
Here are a few examples where the cash-on-cash return is not a good metric to use:
- In a case where a real estate developer wants to identify sites for building properties, leasing them out, and selling them as quickly as possible, the real estate developer will have little regard for long-term calculations as he/she does not intend to hold the property in the long term. For this reason, instead of using the cash-on-cash return, the real estate developer would use the Equity Multiple and the Development Spread (yield-on-cost minus market cap rate) metrics.
- A real estate investor who invests in single-family homes through a fixer-upper strategy and sells the properties 5-7 months later. The investor uses high interest rate hard money loans that have an interest rate of 12%+ and sometimes rents out the home after renovation until it is time to sell. Due to the high interest rate and the short-term of the investment, the debt payment is generally greater than the net income that the property generates, and so the CoC return metric is not a useful one to calculate.
Final Thoughts on the Cash-on-Cash Return
Now that you know when the cash-on-cash return metric should and shouldn’t be used in analyzing real estate investments, you might be wondering: What’s a good cash-on-cash return value to have on an investment property?
There is no specific range that is considered good in real estate investing. Each real estate investor has his/her own preferences, and the value of the cash-on-cash return that is considered good for an investor might not even be considered by another investor.
Finally, to locate investment properties based on their cash-on-cash return value anywhere in the US, make sure to sign up for Mashvisor and search for investment properties using the CoC return and cap rate, as well as several other metrics, values, and aspects of a real estate investment property.