Real estate investing can be a lucrative endeavor if you understand the right metrics to evaluate when analyzing potential investments. One essential metric that every investor should be familiar with is the cash-on-cash (CoC) return. This financial metric offers valuable insight into the performance of an investment property and can help you make informed decisions when building your real estate portfolio. In this article, we’ll explore the concept of cash-on-cash returns, discuss how to calculate them, and highlight their importance in real estate investment analysis. Don’t worry, as always, we at HappyNest will provide an Excel spreadsheet to guide you through the calculations.
What is Cash-on-Cash Return?
In simple terms, cash-on-cash return helps you understand the cash yield you can anticipate from an investment property based on the money you’ve invested. It calculates the annual cash flow generated by the property before taxes are deducted, and then calculates what percentage that represents of the initial cash investment. This metric is particularly useful for investments involving financing, as it accounts for the impact of debt on the investment.
Generally, higher cash-on-cash returns indicate a more favorable investment, while lower returns suggest a less desirable opportunity.
Cash-on-Cash Return vs. Cap Rate
The Impact of Debt
Before we dive deeper into calculating cash-on-cash returns, it’s important to understand the main difference between cash-on-cash returns and cap rates, another commonly used metric in real estate investing. The key distinction lies in the impact of debt on the investment’s returns.
Cap rates show the yearly return on a property without considering any loans or debt, calculated by dividing the net operating income (NOI) by the property’s purchase price. On the other hand, cash-on-cash return factors in the influence of debt on the investment, providing a more accurate picture of an investor’s real return when using financing.
Positive leverage takes place when the cost of borrowing is lower than the property’s cap rate, leading to a cash-on-cash return that’s greater than the cap rate. Conversely, negative leverage occurs when the cost of borrowing exceeds the cap rate, resulting in a lower cash-on-cash return. It’s essential for investors to understand the relationship between cap rate and cash-on-cash return to effectively assess the impact of financing on their real estate investments. If this sounds confusing, don’t worry, as we will explore debt—commonly referred to as leverage—and the potential influence it has on returns in a future article.
How to Calculate Cash-on-Cash Returns:
To make informed decisions about your investments, you’ll need to know how to calculate cash-on-cash returns. In this section, we’ll provide you with the cash-on-cash return formula and explain the two key components required for the calculation: annual pre-tax cash flow and total initial cash investment.
Cash-on-Cash Return = (Annual Pre-Tax Cash Flow / Initial Cash Investment) x 100
To calculate cash-on-cash return, follow these steps:
1. Determine the annual pre-tax cash flow: Calculate the annual cash flow of a rental property by first determining the property’s annual rental income. Then, you must subtract the annual operating expenses, such as property management fees, maintenance costs, taxes, and insurance. The resulting number will be your net operating income (NOI). Once you have calculated the NOI, you can subtract the mortgage payments to arrive at the annual cash flow before taxes.
2. Determine the initial cash investment: Calculate the total amount of cash invested in the property, including the down payment, closing costs, and any initial repairs or improvements.
3. Calculate the cash-on-cash return: Divide the annual pre-tax cash flow by the initial cash investment, then multiply the result by 100 to express the cash-on-cash return as a percentage.
Here’s a simple calculation of a cash-on-cash return to help you visualize it all:
Why are Cash-on-Cash Returns Important?
Investment Performance: Cash-on-cash return helps investors understand the performance of their investments in terms of cash flow. A higher cash-on-cash return indicates a more profitable investment, while a lower return may signal that the property is not generating sufficient cash flow relative to the initial investment.
Financing Impact: By taking into account the impact of financing, cash-on-cash return allows investors to assess the true cost of their investment and evaluate the effectiveness of leveraging debt to finance their property.
Comparison Tool: Cash-on-cash return provides a standardized metric that investors can use to compare different investment properties, making it easier to identify the most profitable opportunities.
Decision-Making: Grasping cash-on-cash returns helps investors make well-informed choices about investing in a specific property or exploring other investment options. This understanding also aids in making decisions about using debt, refinancing, or tweaking investment strategies to optimize returns.
Breaking Down the Calculation Using A Spreadsheet
To help you better understand the cash-on-cash calculations, we’ve attached an Excel spreadsheet that demonstrates the process step by step. This spreadsheet will serve as a useful reference as you begin evaluating potential real estate investments.
Elevate Your Real Estate Investment Game
Cash-on-cash return is fundamental for real estate investors to comprehend and calculate, as it offers valuable insight into an investment’s performance and its suitability for your portfolio. By considering the impact of debt on returns, cash-on-cash return presents a more accurate reflection of an investor’s actual return, particularly when financing is involved.
In addition to understanding the relationship between cap rate and cash-on-cash return, truly mastering the calculation and interpretation of cash-on-cash return can significantly enhance your ability to compare various investment options. By incorporating this calculation into your investment analysis toolkit, you’ll be better prepared to make informed decisions that maximize your real estate investment returns.
Remember, knowledge is power when it comes to real estate investing. Continuously refining your understanding of key metrics like cash-on-cash returns will help you make the most of your investments and build long-term wealth in the world of real estate. Happy investing!
About the Author
Jesse Prince, a combat veteran, CEO of HappyNest, and a seasoned commercial real estate entrepreneur, is passionate about making real estate investing accessible to everyone. With the innovative HappyNest investment app, Jesse empowers investors of all budgets to grow their nest eggs through quality real estate investments. Jesse’s expertise spans various aspects of real estate, including acquisitions, asset and property management, valuation, credit analysis, and real estate securities evaluation.