Cash on Cash Return: The Math Behind Real Estate Investing
Real estate investors and rental property owners often invest in properties to get significant returns from their investments. Purchasing properties might come with uncertainties, like whether the property is investment worthy. That is where certain metrics come in to reduce the risk of loss in real estate investment.
What is cash on cash return?
Cash on cash return, also known as equity dividend rate, is a yardstick used by real estate investors to determine the current profitability of a property as opposed to the total purchase price used to acquire the property initially.
In other words, it is a metric that calculates the cash returns earned on a property for the cash invested in that property. It is conveyed as a percentage and evaluates the cash yield over designated periods like a year. Cash on cash return takes into account debt service on a property.
What is considered a good return on real estate?
The sole aim of every real estate investor is to make a profit. You will make money in real estate if you have a good return on real estate. Good investments require mathematical analysis for you to determine what your returns will look like. This begs the question, what is a good COC return for real estate?
Since there are different ways to measure return on real estate, the answer to this question is subjective. You can contact QC capital to know the best return rate for your type of investment.
Here are different ways to determine the return on real estate:
Cap rate or capitalization rate shows the rate of return on a real estate based on its Net Operating Income (NOI). NOI is the annual income a property generates minus its annual operating expenses. Note that debt payments, capital expenditures, depreciation, and annual mortgage payments are not included in the operating expenses when calculating NOI.
The point of this metric is to get a sense of a property's worthiness irrespective of mortgage, improvements you might make, or depreciation that might occur later on. The Cap rate formula is the NOI divided by the current market value of the asset i.e.
Capitalization rate = Net Operating Income/ current market value of asset.
The question of " what is a good return on real estate?" becomes "what is a good cap rate for investment properties?". Many investors consider a reasonable cap rate to be around 5% to 10%.
A property with a high cap rate does not necessarily mean it is a better investment. What do we mean by this? It could be a good thing if the high cap rate is a result of an increased or high NOI, but if the high cap rate stems from a decreased or low market value of the asset, it indicates higher levels of risk because a decrease in property value could be as a result of deferred maintenance, bad location of the property, etc.
A low cap rate might be good. It just depends on what the reason is. Low cap rates due to property appreciation are good, but the result of the decreased NOI might be at your disadvantage if not appropriately treated.
Return on investment (ROI)
ROI is a metric used to measure an investment's ongoing profitability and efficiency in relation to the investment cost. It measures returns over an entire holding period and the wealth creation factors in real estate like property valuation, property location, tax benefits, inflation hedge, and principal reduction. These are the things that ROI helps to evaluate, that is, returns as a function of appreciation or equity.
The formula for calculating ROI is the annual rental income divided by the total cash invested on the property i.e.
ROI = Annual rental income/ total cash invested
Now, what is a good return on investment?
There are different answers to this question because there are many factors to consider, like the property size and the risk involved with the investment. It all depends on the type of property and the investor involved as long as it meets their investment objectives, but ceteris paribus, a good ROI is usually above 10%.
Cash on Cash return (COC return)
Cash on cash return in real estate investment measures the stability and amount of cash an investment property will generate over a given period. You get to know the rate at which you will recover your initial investment. In other words, it evaluates the return on actual cash invested.
The cash on cash return formula is annual pre-tax cash flow divided by total cash invested i.e.
COC = annual pre-tax cash flow/ total cash invested
APTCF = (GSR + OI) - (V + OE + AMP)
where APTCF= Annual pre-tax cash flow, GSR= Gross Scheduled rent, OI= Other Income, V= Vacancy, OE= Operating expenses (property taxes, management fees, insurance, utilities), and AMP= Annual mortgage payments.
So, how do we know what is a good cash-on-cash return for investment properties is? On average, anything from 8% to 12% is good.
These are the different metrics used in emulating a good return on real estate investment.
How to Calculate cash on cash returns
Here’s an Example:
An investor chooses to purchase a rental property for $2 million. He pays a down payment of $450,000 and takes a mortgage of $1,500,000. The investor also makes a payment of $50,000 for closing costs.
The monthly rental income is $10,000. Moreover, mortgage payments, including principal repayment and interest payments, are $2,000 per month. Insurance and tax on the property cost $1000 per month.
Let's calculate the cash-on-cash return on this rental property. First, we get the annual cash flow by deducting the total annual rental income from the property's operating expenses.
Annual rental income on this property = $10,000 x 12 = $120,000
Total Operating expenses = $24,000 + $12,000 = $36,000
Annual cash flow = $120,000 - $36,000 = $84,000
Then, we will calculate the total cash invested on the property, i.e., the down payment plus closing cost.
Total cash investment = $450,000 + $50,000 = $500,000
Now, we will get the cash on cash return by dividing the annual net cash flow by the money invested in the property.
therefore, the cash on cash return = $84,000/ $500,000 = 0.168 = 16.8%
This figure, 16.8%, is the profit for the year on cash invested initially.
Cash on cash return: Why is the math necessary?
It is essential when determining what property has good investment potential among many options. The formula renders you a simplified and realistic manner of understanding if your investment will be profitable and how your investment in a property can impact your portfolio. It enables you to determine the purchase price at which you will meet your profit goals in the long run of your investment.
Limitations of cash on cash return
Cash on cash return can help you get a picture of your property's potential, but this metric has shortcomings that we will address below. Here are the things cash on cash return does not account for:
Cash on cash return does not consider some specific tax situations. The investor tax rate is something that is not predictable when you are trying to evaluate potential properties because it is dependent on the income of the investor.
Depreciation and appreciation
The cash in cash return formula does not consider any form of appreciation or depreciation. It just measures the return on the actual cash invested.
It does not account for the risks associated with a property. An investor can not just conclude that a 15% cash on cash is better than a 7% cash on cash return because there are risks involved in earning higher returns.
Cash on cash return is a simple interest calculation. It ignores the effect of compounding interest. This implies that properties with low compound interest could be more profitable than other properties with high cash on cash return.
What are factors that increase or decrease cash on cash?
- Rent price: All other factors held constant. If rent prices should increase from a rental property purchased, then the cash flow will relatively increase, thereby causing an increase in the cash on cash return, and if there is a decrease in the rent prices, the return will also decrease.
For example, If you should make a down payment of $40,000 on a rental property with the purchase price of $100,000. The annual rental income is $24,000 with an operating of $7,200 and a mortgage of $6,000.
The pre-tax annual cash flow is $10,800 i.e. $24,000 - ($7200 + $6000). Then we divide the pre-tax annual cash flow by the cash invested to get cash on cash return for the year i.e. $10,800/ $40,000 = 0.27 or 27% return.
Let us assume you increase your annual rental income to $26,000, and other expenses remain constant. The new cash on cash return would be:
$26,000 - ($7,200 + $6,000) = $12,800, and the cash on cash return would be
$12,800/ $40,000 = 0.32 or 32% return.
- Operating expenses: Operating expenses can increase from one year to the next due to inflation, the need for renovation or repair, and supply shortages. If expenses should increase without an increase in annual income, there will be a decrease in cash flow, causing a decrease in the return. Still, most times, rent increases relatively as operating expenses increase.
- Vacancy factor
- Property taxes
- Down payment amount
Differences between Cash on cash return and other real estate metrics
Cash on cash return vs. Return on investment
- Cash on cash return represents investment stability, while ROI represents the profitability of ongoing investment.
- ROI measures the total wealth an investment will create. Cash on cash return measures how much cash the investment will generate.
Cash on Cash return vs. Capitalization rate
- The Cap rate does not include any financing costs such as mortgage costs. Cash on cash return includes this as expenses.
- Cash on cash investment uses cash investment as its denominator, while cap rate uses the property's purchase price.
As a real estate investor, you need to get familiar with using real estate metrics. It’s important to know how, when and what to use for better investment outcomes. Contact QC capital to get more out of your investments and navigate the real estate market with ease.