In this real estate investment article, we want to discuss the meaning, advantages and disadvantages of cash-on-cash return, its popularity among real estate investors, and then examine the cash-on-cash formula with several examples.
So let’s get started.
Cash return (or equity dividend rate) measures the ratio of the property’s expected first-year cash flow before taxes (CFBT) to the real estate investor’s initial cash investment to purchase the rental property.
Here’s the idea: Cash flow is the percentage of cash flow to cash investments.
The popularity and use of cash-for-cash in real estate investing is because it provides investors with an easy way to quickly compare the profitability of multiple investment opportunities. For example, an investor can compare the first-year yield of a real estate investment on a cash-to-cash (or COC) basis with the yield a bank offers on a CD. In this case, for example, the investor may decide to invest in an apartment that returns 7.6% CoC rather than a CD that pays 3%.
Generally speaking, return on cash flow is not considered a particularly powerful tool for measuring the profitability of an income asset because it does not take into account the time value of money. In other words, because it does not compound or depreciate cash over time, CoC is limited to measuring the cash flow of an investment property in the first year of ownership.
However, the cashback is worthless. It certainly gives real estate investors a quick way to compare investment opportunities and similar income-producing properties.
How to calculate
Cash on cash return = annual cash flow / cash investment
what does it mean
Before we look at an example, let’s make sure we understand the components of the formula. This will be critical for you to accurately calculate the cash flow on your own rental property analysis.
1) Annual Cash Flow – This is the cash flow before tax (CFBT) against the cash flow after tax (CFAT). In other words, it is the cash flow for the first year without adjusting for federal income tax. CFBT is calculated by calculating annual rental income less annual operating expenses less annual debt service or loan payments.
2) Cash Investment – This is the total amount of cash needed to purchase the property and includes down payment, points of credit, mortgage and title fees, appraisal and inspection costs.
OK, let’s calculate cashback.
The profitability of a six-room apartment building is analyzed as follows. Each of the six units collects $1,000 a month. They estimate that first-year operating expenses will be $28,800. Your mortgage requires a $126,000 down payment, a credit score of $2,940, and a monthly loan payment of $1,956. Estimate your closing costs, including the written description, title, inspection and appraisal fees, at $2,100.
First, calculate the annual cash flow:
Total Projected Income $72,000 ((6 units x $1,000) x 12)) Less Operating Expenses $28,800 Less $43,200 (Net Operating Income) Mortgage Payment $23,472 ($1,956 x 12) = Cash on hand $19,728
Next, calculate your financial investment:
Down payment of $126,000 plus credit points of 2,940 plus closing costs of $2,100 = $131,040 cash investment
Finally, calculate the CoC:
Cash Return = Annual Cash Flow / Cash Investment, or, $19,728 / $131,040 = 15.06%
OK, now let’s implement it.
You are trying to decide where to invest $126,000 in cash. You can invest in a 3% T-bill at your local bank or, as soon as you find it, buy a six-unit rental property and earn a 15.06% return on cash. What will you do next? You may want to do a full real estate analysis on the property and look at other key returns and measures. Although on the surface, investment real estate is a very sensible real estate investment choice, you cannot make a decision without more information and a thorough real estate analysis.
But here is the caveat. Make sure you use reliable property data for your analysis; Make sure everything the seller or agent gives you is complete and accurate. Calculate all numbers and property information concisely and carefully.
For this reason, we have to protect our environment.