What is Cash on Cash Return in Real Estate Investing
There are many nuances in the real estate investing space and knowing what to consider when making a purchase is a must for savvy investors. From purchase price to the average rental prices in town to the financing opportunities, everything needs to be scrutinized before putting in an offer.
In the current climate, understanding what a good cash-on-cash return is key to evaluating the potential – or current – success of a real estate investment. This is what you need to know about cash-on-cash returns, including red flags, green flags, and other points of analysis investors should keep in mind.
What is Cash-on-Cash Return?
For investors of all kinds, determining the benefits of an investment is key. No one wants to sink money into an unprofitable investment, so doing the math on profits is non-negotiable. However, doing this kind of breakdown can function differently based on the investment in question. And, as real estate investors know, assets like rental properties are often treated differently than investments like stocks and bonds
Instead of considering a return on investment, or ROI, as is typical for other kinds of assets, real estate investors generally focus on cash-on-cash return instead. Sometimes referred to as equity dividend rate, cash-on-cash return is effectively a way to estimate or determine the income generating potential from a property in the context of the cash invested in a purchase. The calculation is:
cash flow (net operating income) / cash investment
Rather than simply subtracting initial cash investment from net operating income to show overall profits for a particular piece of real estate, this formula determines cash flow as a proportion of the investment amount. The higher the cash-on-cash return, the better an investment property can be expected to perform. A low cash-on-cash return, or even worse, a negative one, does not bode well for what a property can deliver for its owner.
While this sounds similar to ROI, there’s a key difference. ROI looks solely at the returns on an investment, or the profits earned on a regular basis. Cash-on-cash return takes the entire investment into account, including the amount invested into purchasing a property before any income can be collected. This allows buyers to make sure a property investment won’t backfire down the road.
Breaking Down the Formula
As stated, cash-on-cash return is simply calculated by dividing cash flow by cash investment. But what does this really mean?
In this context, cash flow refers to annual income before the impact of taxes. This is calculated by taking all the cash collected over the course of a year, prior to income or property taxes, less the relevant operating expenses. So, if you offer a house for rent for $2,500 per month have operating expenses such as homeowner provided insurance, utilities, maintenance, and repairs that total $6,000 for the year, annual cash flow would equate to $24,000.
This number is then divided by your cash investment, which refers to all the cash that went into the process of buying a property and turning into a suitable place to live. This can include the cash put down during the sales process, closing costs, loan fees if applicable, and money spent rehabbing a property before welcoming tenants. It does not, however, includes any operating costs associated with keeping the property in business, like insurance, maintenance and upkeep, and any utilities not covered by renters; this is instead incorporated into net income above.
Once these expenses have been isolated, it’s time to move on to calculations and what they mean for the future of an investment property.
Buying an Investment Property Without a Loan
How cash-on-cash return functions can be highly dependent on whether a loan is required during the purchase process.
Say, for example, a California rental property costs $300,000 to purchase. With closing costs of 5%, this is an initial cash investment of $315,000 outright to acquire a property. On top of that, $15,000 in rehab costs may be required to bring the property up to the standards required for tenants in the area. This comes to $330,000 before any income can be generated.
Once a tenant moves in at a rate of $2,500 per month in rent, rental revenue generated for the year will equal $30,000. However, there are operating expenses associated with keeping a rental property going, which may equal $6,000 for the year, resulting in pre-tax income of $24,000.
Once these figures have been determined, they can be plugged into the cash-on-cash return formula: $24,000 divided by $330,000. This equals a cash-on-cash return of 7.2%.
Buying an Investment Property with a Loan
When a loan is involved in the investment property purchase process, calculating cash-on-cash return does become a little less straightforward.
A loan usually comes with both a borrowed amount principal and a down payment. In the above scenario, where a home costs $300,000, a cash down payment would likely be $60,000 – 20% of the purchase price. With the assumed $15,000 in closing costs rolled into the cost of the loan, and the $15,000 in rehab costs paid with cash on hand, this equates to an initial cash investment of $75,000, which is just a fraction of what would be paid if cash is used to fund the entire purchase up front, a significant advantage for property investors.
During this stage in the calculations, the loan principal should not be added into the initial investment, because that cash outlay has not yet materialized. The loan amount will be gradually added in time as payments are made.
However, the annual loan payment amount is deducted in the net operating income calculation. With a 5% interest rate and a loan amount of $255,000 and assuming a 20-year loan term, approximately $20,000 will be paid in interest and principal in the first year of operations. When subtracted from the $24,000 in rental income, this leaves an NOI of $4,000.
With these figures, cash-on-cash return will be $4,000 divided by $75,000, or 5.3%. This is notably lower than the 7.2% determined for an all-cash purchase. However, purchasing with a loan has distinct advantages that does not consider paying with cash, such as, the advantage of leverage to use your available cash to purchase other properties, having an emergency fund for current properties, and leveraging tax advantages into paying less with loans to offset a potential cash return. Check with your advisor, but the most successful property investors properly use loans to purchase more properties that they otherwise would be able to.
Interpreting Cash-on-cash Return
Calculating cash-on-cash return is straightforward, particularly for those who keep good records and take a rental property investment seriously. However, in a vacuum, the numbers don’t necessarily indicate anything specific. So, what does cash-on-cash return mean, and is paying for a home in cash always the right choice?
As with many things in investing, in real estate, and in general, it all depends. In some cases, putting down cash at the start, if feasible, can certainly lead to a higher cash-on-cash return. Without the stress of loan payments, including interest expenses, which may require relying on rental income, it’s easier to generate returns. However, if loan terms are favorable (and we have loan programs to help), property values are higher than available cash, and a property can demand high rents, a loan can be a beneficial choice.
Making a choice to buy based on an estimated cash-on-cash return can be crucial to success, so understanding the differences between calculating with and without a loan is always an exercise worth performing.
What Is a Good Cash-on-cash Investment?
Knowing how to calculate cash-on-cash return is a good skill for all real estate investors, but knowing the answer isn’t always helpful. Without a way to determine a good return, doing the math is meaningless. So, what is a good cash-on-cash investment?
A frustrating answer but again, it depends on the property itself and the risk tolerance of the investor. Even experts can’t agree; some argue for 8% or more, while others wouldn’t consider a rental property without a cash-on-cash return of less than double digits.
When evaluating a property, it’s important to consider your personal goals. What kind of income you would like to earn from a rental property, how much risk you are willing to take on, how aggressive you are in your investment pursuits, and how many other properties are a part of your portfolio can all play a role. It’s also possible to work with other area investors to learn industry norms and expectations, and how close projections are to actuality once a rental property is up and running. The local market may also play a role; if prices are expected to rise, it can be worth rolling the dice, even if numbers initially look less favorable.
It’s also important to remember that there are other metrics involved. Cash-on-cash return covers a key financial facet of real estate investment, but it’s just one dimension. Experienced investors know that there’s more than just profit margins to consider when spending hundreds of thousands of dollars on a property.
Is Cash-on-cash Return the Only Metric to Know?
Cash-on-cash return is crucial for real estate investors to assess when considering real estate for income purposes, but it’s not the only formula to keep in mind. There are other high level analyses investors can do when evaluating the viability of a property. One of these, which is similar but serves its own purpose, is capitalization rate.
Capitalization rate seems like roughly the same thing, but uses a different formula based on the current market value of a property:
(Net operating income / current market value) x 100
Alternately, it can be calculated as:
(Net operating income / sales price) x 100
This formula considers housing value in a way cash-on-cash return does not, as the value of a property certainly plays into its worth to an investor. However, it can’t consider the differences in financing opportunities. When it seems like there’s no measurable difference in how a property is paid for, the value of cash-on-cash return diminishes, but when there’s potential volatility, the importance can’t be overstated.
There are many things to consider when evaluating a rental property for viability. Cash-on-cash return is among the most important, as it can be an indicator of profit opportunity in a particular property. While not the only metric to keep in mind, understanding the ins and outs, including the differences in cash vs. loans when buying property, can make all the difference in ensuring your success in a rental endeavor. A Westpark Loans officers can find a program to help you reach your goals.
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