154: What is a Good Cash-on-Cash Return?

SHOW NOTES FOR EPISODE 154: WHAT IS A GOOD CASH-ON-CASH RETURN?

A cash-on-cash rate of return is one of the more popular rates of return associated with rental property analysis.  Ironically, though, it’s not a particularly powerful statistic.  In this episode, Bill explores cash-on-cash returns and attempts to answer the question, “What is a good cash-on-cash return?”

First off, I have to say:

• You should never rely on a single ratio or metric to assess if a property is good or bad, you need to look at other key indicators
• I admit, in my initial screening of properties, I put a lot of weight on “cash flow” — but then, if cash flow looks good, I dig deeper by looking at other factors

The cash-on-cash rate of return is one of the more popular rates of return associated with rental property analysis.  Ironically, though, it’s not a particularly powerful statistic. In fact, real estate investors would be wise to rely on other better ways to measure the profitability of an income property investment.

Still, because cash-on-cash is not without its supporters, it seemed like a good idea to take a closer look at those of you new to real estate investing.

Overview

The cash-on-cash rate of return (or CoC) measures the ratio between the total amount of cash flow a rental income generates in a particular year and the total cash investment a real estate investor initially makes to purchase the property.  In other words, CoC is computed because it shows the yield an investor might expect to collect on his or her cash investment.

The Cash on Cash Return is a ratio based on the annual cash flow divided by the equity you have invested into the property, the formula is;

= Cash Flow / Invested Equity.

Utilizing cash-on-cash to evaluate a property has pluses and minuses

Pros

• It’s easy to calculate
• It provides a quick and easy way to make “first glance” comparison between various investing opportunities. For instance, cash-on-cash enables investors to determine the highest cash return between several real estate investing opportunities as well as to other types of investment opportunities such as a CD.

Cons

• It’s limited to the rate of return on the cash flow before taxes
• It doesn’t account for the time value of money so it’s most effective as a measurement in the first year of ownership only

You would rarely hear anyone talk about cash-on-cash return outside the world of real estate investing.  Most other investments such as stocks are evaluated by the return on investment (ROI), not the cash-on-cash return.

In order to calculate the ROI, you need to know all the money that you made from an investment in addition to the cash that you invested.  However, you cannot possibly know how much a rental property will bring you in total before you actually sell it (primarily because you do not know what will happen over time and the equity numbers yet).

A popular and easy metric to use in real estate investing is the cash-on-cash return.   Also called the “equity dividend rate,” the cash-on-cash return is calculated by dividing the cash flow (the net operating income -before tax) by the amount of cash initially invested

So the formula is this:

Cash-on-cash return = net operating income/total cash investment

The net operating income (NOI) is simply the annual rental income minus the operating expenses.

The total cash investment is all the cash that you have to pay out-of-your-pocket, in order to make your rental property operational. This means, the amount of money to pay to purchase it, closing costs, rehab costs, and loan fees (if you take a loan from the bank).

Let’s look at an example which will hopefully make things clearer.

Here is the situation where there is no loan involved:

So, you buy a rental property that costs $250,000, and you pay the full amount in cash (yes, you are one of those few lucky people who have $250,000 available to invest in real estate).

You need to pay another 5% (or $12,500) in closing costs and rehab costs. Don’t forget to factor in the rehab costs.  It doesn’t make sense to calculate the cash-on-cash return on your property if you ignore this cost because you cannot rent it out if it’s not in good condition.  So, to get your total investment:

Total cash investment = $250,000 + $12,500 = $262,500.

You can charge $2,100 of rent per month for your rental property.  So,

your annual rental income is 12 x $2,100 which equals $25,200

Using the 50% rule, you can estimate the operating expenses at half of the rental income.  So, this will leave you with:

NOI = .50 x annual rental income = 50% x $25,200 = $12,600

Cash on cash return = NOI/total cash investment = $12,600/$262,500 = 4.8%

So, the cash on cash return which you could generate from this rental property is 4.8% IF you paid the entire price in cash.

Example: With a Loan

Now let’s face it.  How many of us can actually take $262,500 out of our pockets to pay for a rental property in cash?  Not that many, right?  Also, why in the world would you want to tie up all your cash in one property, when, using leverage, you could buy 4 properties valued at $250,000, using 25% down with a mortgage loan on each?  But, that’s the power of leverage and the subject for another Fun Facts Friday.

So, on to our example.  Let’s look at the more realistic (and smarter) scenario in which a real estate investor takes out a loan from the bank to finance the purchase of his/her $250,000 rental property.

In order to allow us to compare the two cash-on-cash return rates (without a loan and with a loan), we will consider the same property as above.

So, we are buying the $250,000 rental property and pay 25% in cash for a down payment now:

Down payment = 25% x $250,000 = $62,500

We include the same closing and rehab costs of 5% of the total value, adding up to $12,500. Now:

Total cash investment = $62,500 (down payment) + $12,500 (closing costs and rehab)= $75,000

Don’t get confused at that stage. When calculating the cash-on-cash return, we only take into consideration the cash money that we pay right away, which means the down payment.  You should not include the bank loan amount here – only the down payment.

Now we need to calculate the NOI.  In addition to the rental income (which you’ll add) and the operating expenses (which you’ll minus), we have to add the debt service to the equation (which you’ll minus).  Assuming an 4% interest rate loan:  Debt service = 4% x $187,500 (the loan balance)= $7,500

So:

NOI = $12,600 (rental income minus 50% expenses) – $7,500 (mortgage payments or debt service) = $5,100 (your NOI amount)

To get the new cash on cash return, simply:

Cash on cash return = NOI/total cash investment = $5,100/$75,000 = 6.8%

Thus, the cash on cash return which you will generate from this rental property if you take a bank loan is higher than if you paid cash because you put less cash into the deal out-of-pocket.

What is a Good Cash on Cash Return?

Experts disagree on the numbers.  Some say that anything above 8% is good and that they aim for something in the range 8-12%.  Other investors would not even bother to think about a rental property if it doesn’t promise them a cash-on-cash return of 20%.  The cash-on-cash return also varies from one kind of property to another and from one location to another.

Because the cash-on-cash return is a simple metric, it does not tell us everything about a rental property.  For example, it does not factor in appreciation or tax benefits. Thus, it is only an indication of whether a real estate investment could be a good idea or not.  However, before making the final decision, you have to conduct a more sophisticated, in-depth analysis to guarantee the return that you are looking for.

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