March 14, 2023
Learn about how cash on cash returns are used when looking for investment opportunities in real estate and beyond.
Cash on Cash Return Calculator
Key Takeaways:
- Generally, a cash on cash return of 8-12% is considered favorable.
- Leverage can increase cash on cash return by allowing investors to purchase a larger investment with a smaller initial cash outlay. However, it also increases the risk of the investment.
- Cash on cash return and ROI are different metrics. Cash on cash return focuses on the cash flow generated by an investment, while ROI considers both cash flow and capital appreciation.
- A negative cash on cash return occurs when the annual pre-tax cash flow is negative, which may result from high operating expenses, vacancy rates, or other factors that decrease the cash flow generated by the investment.
What is Cash on Cash Return?
Cash on cash return is a financial metric that measures the annual pre-tax cash flow that a particular investment generates relative to the amount of cash invested. It is often expressed as a percentage.
It's particularly useful for evaluating income-generating properties, such as rental properties, and for comparing investments that require different amounts of cash investment.
Calculating Cash on Cash Return
The formula for calculating cash on cash return is:
Cash on Cash Return = (Annual Pre-Tax Cash Flow / Total Cash Invested) x 100
Let's say you invest $100,000 in a rental property and receive an annual pre-tax cash flow of $10,000. Your cash on cash return would be:
Cash on Cash Return = ($10,000 / $100,000) x 100 = 10%
What's a Good Cash on Cash Return?
A good Cash on Cash Return varies depending on several factors, including the type of property, the location, the investor's risk tolerance, and market conditions. In general, a higher CoC return is more desirable, as it indicates a better return on the invested capital.
As a rough guideline, many real estate investors consider a CoC return of 8-12% to be a good benchmark. However, this range may not be universally applicable, and investors should consider their specific investment goals and risk tolerance when evaluating CoC returns.
Why is Cash on Cash Return Important?
Cash on cash return is an essential metric because it helps investors understand the actual cash flow an investment generates. It provides a clear picture of the investment's performance, allowing investors to make informed decisions based on their financial goals and risk tolerance.
Advantages of Cash on Cash Return
- Simple and easy to understand.
- Considers the actual cash flow generated by the investment.
- Helps in comparing different investment opportunities.
- Provides a quick snapshot of an investment's performance.
Disadvantages of Cash on Cash Return
- Ignores the time value of money.
- Does not consider the appreciation of the investment.
- May not account for all relevant expenses and taxes.
Cash on Cash Return vs. Other Investment Metrics
Return on Investment (ROI)
ROI is a broader metric that considers the total return on an investment, including both cash flow and capital appreciation. While cash on cash return focuses solely on cash flow, ROI provides a more comprehensive view of investment performance.
Internal Rate of Return (IRR)
IRR is a more sophisticated metric that considers the time value of money and projects the annualized rate of return over the entire investment horizon. Unlike cash on cash return, IRR accounts for the timing and magnitude of cash flows, making it a more accurate measure of investment performance. However, effective on-the-fly calculation of IRR can be impractical for many investors.
Capitalization Rate (Cap Rate)
Cap rate is a real estate-specific metric that compares the annual net operating income (NOI) to the property's purchase price. It is useful for evaluating the potential return on a property, but it does not consider the financing structure or cash flow, unlike cash on cash return.
Factors Influencing Cash on Cash Return
- Initial investment amount
- Financing terms and interest rates
- Rental income
- Operating expenses
- Vacancy rates
- Market conditions
How to Improve Cash on Cash Return
- Optimize financing terms to reduce interest rates and increase cash flow.
- Increase rental income through property improvements or market analysis.
- Minimize operating expenses by implementing cost-saving measures.
- Maintain a low vacancy rate through effective property management.
Cash on Cash Return in Real Estate Investing
Residential Properties
In residential real estate, cash on cash return helps investors determine if a property will generate sufficient rental income to cover mortgage payments, taxes, and other operating expenses. It can be a useful tool for identifying profitable rental properties and making sound investment decisions.
Commercial Properties
Commercial real estate investors also use cash on cash return to evaluate potential investments. It can help them compare different properties based on their cash flow potential and overall investment performance.
Cash on Cash Return in Other Investment Types
While cash on cash return is primarily associated with real estate investing, it can also be applied to other investment types, such as stocks and bonds. In these cases, the metric can help investors understand the cash flow generated by their investments relative to the initial cash outlay.
Additional Cash on Cash Return Examples
- An investor purchases a rental property for $200,000 with a down payment of $50,000 and a mortgage of $150,000. The property generates an annual pre-tax cash flow of $12,000. The cash on cash return is ($12,000 / $50,000) x 100 = 24%.
- An investor buys a commercial property for $1,000,000 with a down payment of $250,000 and a mortgage of $750,000. The property generates an annual pre-tax cash flow of $75,000. The cash on cash return is ($75,000 / $250,000) x 100 = 30%.
Common Mistakes to Avoid
- Focusing solely on cash on cash return without considering other factors, such as market conditions and property appreciation.
- Ignoring the time value of money and the impact of inflation.
- Not accounting for all relevant expenses and taxes when calculating cash on cash return.
What Cash on Cash Returns Tells Us
Cash on cash return is a valuable metric for investors, particularly in the real estate sector. It helps investors evaluate the cash flow generated by an investment and make informed decisions based on their financial goals and risk tolerance. By understanding cash on cash return and its limitations, investors can better navigate the world of investing and optimize their investment strategies.
