There are a variety of metrics used by real estate investors to determine whether an investment opportunity is a good one or not. Cash-on-cash return is a common one. With the sea of deals out there, metrics like these are essential tools that help investors distinguish between the good from the bad.
But to utilize the cash-on-cash return metric properly, you need to know how it works.
So let’s dive into it.
What We Know About Cash-on-Cash…
Cash-on-cash return is used to measure the yearly return an investor makes on a given property in proportion to how much money they spent paying off the debt in a given year. This metric is used by real estate investors to determine “the cash income earned on the cash invested in a property.”
Cash-on-cash as a metric is mainly used by commercial real estate investors, like multifamily syndicators.
Cash-on-cash return, sometimes referred to as the equity dividend rate, does not take into account “income tax effects, resale implications, future cash flows, and loan principle deductions.”
Why Cash-On-Cash Is NOT Some Arbitrary Metric
Cash-on-cash (COC) returns are important. They can be used to assess the impact of leverage on a deal and its profitability. This metric gives investors a snapshot of what they might be able to expect to make as a return on a deal. COC also allows investors to compare different asset classes and investment opportunities to each other.
When it comes to financing, the more financing an investor uses on a deal, the higher their COC will be. This is because they need less of their own money to buy the deal.
COC is also used by investors to analyze a deal’s business plan, and project possible capital distributions throughout the hold period of the asset.
COC is typically utilized for deals that will have long-term financing. When an investor uses debt to buy a property, this makes the return on investment (ROI) differ from the COC. Investors can use COC to identify the kind of terms they need on their financing in order to achieve their desired returns.
An important relationship to understand is the correlation between COC and the amount of equity an investor puts into a deal. The less equity an investor puts, the higher their COC (holding other factors constant).
COC also gives investors more information about the expenses at a property. A property with high expenses results in a lower COC, holding other factors constant. COC allows prospective investors to assess costs and determine if there are ways they can reduce them to increase their COC.
When it comes to assets you own, COC gives investors a quick way to keep a pulse on their deals. COC increases when a multifamily property generates more income, like from higher rental rates. If vacancy at a property increases, COC goes down.
But Why Not Consider Taxes For Cash-on-Cash?
COC is calculated without taking income taxes into account because income taxes can vary from investor to investor. Taking it out of the equation (literally and figuratively) allows investors to make more equitable comparisons between different real estate investments and their projected outcomes. It allows for more of an “apples-to-apples comparison.”
Cash-on-Cash vs Return On Investment
A majority of commercial real estate properties are purchased with some kind of debt. Because of this, “the actual cash return on the investment differs from the standard return on investment (ROI).” While ROI is the total return on an investment, including the cost of using financing, cash-on-cash return only calculates the return on the capital invested. COC therefore offers investors a clearer picture of how a deal is performing.
Cash-on-Cash vs Internal Rate of Return (IRR)
IRR is the “total interest earned on money invested.” While COC is based on a yearly basis, while IRR measures total income throughout the entire hold period of the asset. IRR is calculated with the notion of the “Time Value of Money” principle. This principle assumes that one dollar today is more valuable than a dollar in the future.
Cash-on-Cash vs Cap Rate
Cap rates have been confusing investors since the beginning of time (just kidding, but not really). Cap rates are calculated with the assumption that the property is being purchased using all cash (ie no debt). If a property was bought all cash, then COC would equal the cap rate. But we know this is hardly ever the case.
How Is Cash on Cash Calculated?
Cash-on-cash returns are calculated by determining how much money an investor puts into a deal in relation to how much income the property generates for the investor over one year.
Here are the steps to calculating COC:
Net Income: An investor will first determine what the net income of the property is over a year. To do this, you can take the gross income and subtract operating expenses (and debt service if applicable). Remember: this is PRE-TAX cash inflows!
Total Cash: Then, divide the net income by the total cash spent for the property. This does NOT include taxes!
Percentage: Take the number generated above and convert it into a percentage.
Ta Da!: You’ve got your cash-on-cash return!
Caution: Cash-On-Cash Risks!
COC goes up the more leverage you use to purchase a property. But, debt comes with risk, and the more leverage, the higher the risk typically. In the event that the net operating income at the property decreases, the investor will still be expected to make principal and interest payments, and in worst case scenarios, they might even have to pay it all back prematurely.
Also, since COC doesn’t take into account income taxes, this is still something that an investor should factor into their investment decisions.
How Investors Milk Cash-On-Cash Returns
Investors can simply take out a bigger loan to buy the property. As we mentioned earlier, this means that the investor would need to use less of their own equity to fund the deal, which would push their COC up. But this comes with risks.
Savvy investors make sure the net operating income they are projecting is accurate.
They also explore multiple different financing options, to make sure they get the most favorable terms possible.
By now, it’s clear why cash-on-cash returns are such a powerful tool for investors. This metric allows us to make wise investment decisions to progress towards our goals and enhance our lives.
COC enables investors to determine which investments are best for them by providing an efficient way to measure yearly returns in relation to money invested. It also gives investors insight into the impact of leverage and the soundness of their business plans and distribution projections.
Cash on cash return isn’t just a metric - it’s a powerful tool investors can use for long-term success in real estate investing.