What is a Cash on Cash Return on Real Estate?

The post What is a Cash on Cash Return on Real Estate? by Marc Guberti appeared first on Benzinga. Visit Benzinga to get more great content like this.

Real estate investors use various metrics to assess their investments and determine if they are receiving a suitable return on investment (ROI). Cash on cash returns give investors a glimpse into how their money is working for them. This statistic measures a property’s return by comparing annual cash flow to the corresponding mortgage payments. Many real estate investors, especially commercial property investors, use this metric. This guide will lay out how cash on cash returns work and when to use them for your analysis.

Exploring the Cash on Cash Return Formula in Real Estate Investing

The cash on cash return formula helps real estate investors assess the return on their cash flow. Knowing this number can help investors adjust rent prices and operating expenses to make the number more desirable. This metric can also help investors decide whether they should buy additional properties in the area or look somewhere else for higher returns.

Understanding the Cash on Cash Return Formula

The cash on cash return formula has two components:

• Annual pre-tax cash flow: The amount of money you make in one calendar year from rent and other income sources from the property before taxes.
• Invested equity: The amount of money you put into the mortgage within the same calendar year.

An investor wouldn’t use the 2022 annual pre-tax cash flow and the equity they invested in 2021 to arrive at the cash on cash return. An investor would look at 2022 for both years and ignore the built-up equity from years before or after 2022.

Calculating the Annual Pre-Tax Cash Flow

The annual pre-tax cash flow includes all of the property’s income sources. While rent usually makes up the bulk of cash flow, a property can also accumulate cash flow through parking spaces, events and other income streams. Investors also have to consider operating expenses, such as property management, and other relevant factors when assessing their pre-tax cash flow.

If a property generates $100,000 from rent and other income sources, and the owner pays $60,000 for operating expenses, the pre-tax cash flow is $40,000.

Determining the Invested Equity

The invested equity is based on the amount you invested into the property for the calendar year. If this is the first year you purchased the property, you will have to include the down payment in your calculator. This can result in a lower cash on cash return for the first year, but it may not accurately reflect the property’s potential. Future years only include the mortgage payments made for that year instead of also including the down payment and previously built-up equity. 

Applying the Cash on Cash Return Formula

The cash on cash return formula only has two numbers you need to find. Once you find them, calculating the rest of the formula is straightforward. Assume an investor pays $80,000 per year for the mortgage and other expenses while generating $100,000 per year from the property. Knowing the annual numbers helps investors arrive at the cash on cash return for the year.

Cash Return = Annual Pre-Tax Cash Flow / Invested Equity

Cash Return = ($100,000 – $80,000) / $80,000

Cash Return = $20,000 / $80,000 = 25%

This calculator demonstrates a 25% cash on cash return from the property. The calculation includes deducting the annual income from the annual expenses to arrive at annual pre-tax cash flow.

Interpreting the Cash on Cash Return

Cash on cash return lets investors know how their cash is performing. It offers a more accurate gauge of a property’s current performance than the return on investment, a metric that focuses on the property’s total debt instead of investments made within a calendar year. Sustainable real estate investments exhibit positive cash on cash returns.

Limitations and Considerations

The cash on cash return has its perks, but it also has a few limitations to consider. This metric does not anticipate changes to the property’s value. Appreciation won’t increase cash on cash returns but will have an impact on ROI. Depreciation also won’t show up in a cash on cash return. 

Understanding the Difference Between Cash on Cash Return and Return on Investment (ROI)

Cash on cash return and return on investment are two formulas real estate investors use to gauge properties. Using both formulas and knowing how to interpret them can shed light on a property’s profits.

Key Differences Between Cash on Cash Return and ROI

Cash on cash return and ROI have a few differences. Knowing the nuances can help you decide which formula is more relevant for your real estate investments.

Scope

Cash on cash returns focus on cash flow and expenses for the current year. ROI looks at cash flow and property appreciation. ROI also considers all your mortgage payments, not just the ones made in the most recent calendar year.

Timeframe

Return on investment looks at the lifetime returns of an asset compared to its total expenses. Cash on cash returns have a narrower approach and focus on annual cash flow and expenses.

Cash Investment

ROI looks at everything that went into an investment, including the financing. Cash on cash returns only looks at the cash invested on an annual basis.

When to Use Cash on Cash Return vs. ROI

Cash on cash returns are better if you want to assess how a real estate investment is performing right now. This metric can also help you see a trend if it deviates from the ROI. An investment’s ROI is more useful when analyzing the long-term returns of a property, and you want to include appreciation in your calculation. ROI is also more useful if you intend on selling the property and want to calculate your total return if you sell at a certain price.

Pros and Cons of Cash on Cash Return and ROI

Cash on cash returns have several advantages. This metric helps investors assess the current finances of their investments and gauge how they can increase cash flow. Cash on cash investments ignore appreciation and depreciation, which can help long-term investors who solely focus on cash flow. The argument these investors may make is that appreciation is unrealized gains until the property gets sold.

However, some people want appreciation included, and cash on cash returns does not deliver on that. ROI gives you a better idea of long-term returns and can help you assess a good exit price for your property. Investors use ROI to determine how their investment has performed, while cash on cash returns help investors see how their cash flow is performing each year.

Determining a Good Cash on Cash Return in Real Estate

A good cash on cash return is 8% to 12%, and that number will increase once you pay off the mortgage. While this is a general guideline, it’s important to review cash on cash returns in your area. Some locations have higher returns than others, and an acceptable cash on cash return rate in one area may be undesirable in another area. 

Investors should review the past performances of investments and their cash flow to gauge what cash on cash returns can look like. Setting criteria around cash on cash returns, ROI and other factors can lead to better investments and help you filter out unprofitable assets.

Factors Affecting Cash on Cash Return

Cash on cash returns depend on several factors. Knowing what influences this metric can help you earn higher returns with your properties.

• Rental income: Higher rental income increases your cash on cash returns.
• Property expenses: Lower property expenses improve your cash on cash returns.
• Mortgage payments: Lower mortgage payments improve your cash on cash returns.
• Vacancy rates: Lower vacancy rates improve your rental income, which means higher cash on cash returns.

Interpreting Cash on Cash Return: What Does it Signify?

Cash on cash returns signify a property’s profit margin. A higher cash on cash return indicates the investment is sustainable. However, if the cash on cash return becomes negative, it means the investor is spending more money on the property than what they receive in rental income.

Higher cash on cash returns give investors more flexibility and allow them to take more risks. They can more confidently buy additional properties and capitalize on healthy margins. However, an investor may have to get defensive with a low cash on cash return, especially if it becomes negative.

Know Your Cash Flow

Cash flow helps real estate investors hold onto their properties, capitalize on leverage and build long-term wealth. Each year, the mortgage balance gets a little smaller, and you can reap profits along the way. Analyzing your cash on cash returns gives you a snapshot of how your investment property is currently performing. Combining this metric with ROI can help you detect trends with your property.

Frequently Asked Questions

The post What is a Cash on Cash Return on Real Estate? by Marc Guberti appeared first on Benzinga. Visit Benzinga to get more great content like this.