One of the most exciting things about real estate investing is that there are so many ways to create value. On the other hand, one of the most challenging things about real estate investing is that there are so many ways to create value, and gauging that value isn’t always trivial. There are many ways to measure the profitability of an investment property, but one of the most important for any investor is cash-on-cash return.
Let’s look at this deceptively simple metric, how it works, why it’s so important, and how you can start leveraging it to build greater profits in your real estate portfolio.
What Is Cash-on-Cash Return?
Cash-on-cash return is one of the most critical metrics real estate investors have at their disposal when determining a property’s overall return on investment.
As the name implies, cash-on-cash return effectively measures an investor’s net income on a property divided by investment outflow.
Also known as the cash yield on an investment property, cash-on-cash return is most often used to measure the performance of commercial real estate investments. It is a simple calculation that tells an investor their annual return on a property relative to the amount they invested in the property during that same year.
Where Cash-on-Cash Return Is Most Helpful
There are a few ways cash-on-cash return can be vital in assessing the profitability of a property.
First, it is one of a real estate investor’s primary tools in evaluating whether or not to invest in a property initially. Along with other important factors about the property itself and market conditions, an estimated cash yield can contribute to the overall valuation of a property.
For investment properties you already own, this metric can help you comprehensively understand how each one is performing. In addition, investors can leverage this info to compare cash flows across multiple properties and gauge which are providing the most net cash for the amount invested.
Another way that cash-on-cash return can be helpful is in forecasting the future value of an investment. While it is not generally possible to predict the exact future returns of a property, this number can still be a valuable guide for estimating future rates of return.
Factors That Impact Cash Yield
Many variables influence cash-on-cash return, which may cause it to fluctuate significantly.
Of course, the performance of the underlying investment is one of the main factors driving the calculation. Things like your net cash flow, total equity, and leverage against the property all weigh into this figure, as well as market conditions.
However, it’s important to note that other factors of your situation and how you set up your investment may also play a role in this result. For instance, the cash-on-cash return of a property will be very different in a year that you bought or sold it than in a year where you owned it for the entire period.
As we explore this valuable calculation further, it is worth keeping in mind that all these things and more can play a role in its final result. So while it is a helpful tool for determining if and to what extent a real estate investment is profitable, it is always best to consider multiple data points before making significant decisions.
How to Calculate Cash-on-Cash Return
The formula for calculating cash-on-cash return is pretty straightforward and usually doesn’t require any kind of special calculator. It has only two primary inputs: your cash flow and your cash invested. So, to calculate your cash-on-cash return for a property in a given year, simply divide the former by the latter.
To find your cash flow, gather all the annual pre-tax income from the property, including:
- Rent payments
- Proceeds from a sale
- Other income
Then, subtract all of your operating expenses, such as:
- Purchase costs
- Rehab-related expenses
- Insurance premiums
- Maintenance costs
- Mortgage payments
The result of subtracting your outflows from your inflows is your cash flow.
Your cash invested includes everything you have invested into the property in the given year. This number should match the sum of your expenses, which you used to calculate cash flow.
Once you have these two numbers, divide one by the other (cash in / cash out), and the result is your cash-on-cash return.
Though the final calculation for cash-on-cash return is as simple as dividing one number by another, it can be easy to lose track of everything that goes into those two inputs. So, let’s further illustrate the formula by breaking it down into a few simple steps.
For this example, consider a hypothetical real estate investor named Alice. Alice wants to determine the cash-on-cash return of one of her commercial properties for last year.
Alice owned this property for the entirety of last year. She collected $10,000 in rent per month from her property, with only one month of vacancy.
Since she held the property for the whole period, she did not make any income from selling it, nor did she earn any other source of income on the unit besides rent. In total, it earned her an inflow of $110,000 for the year.
Expenses (Cash Invested)
The monthly mortgage payment on the property was $8,000, for a total of $96,000 over 12 months. Alice also paid a total of $4,000 in various maintenance costs and $2,000 on insurance premiums during the year.
There were no other fees, and since Alice already owned the property at the beginning of the year, we do not have to factor in a down payment or any other purchase-related expenses. In total, her outflow for the year was $102,000 ($96,000 + $4,000 + $2,000).
Investment cash flow is simply income minus expenses. In Alice’s case, that comes to $8,000 ($110,000 – $102,000).
From here, we have everything we need to derive the annual cash-on-cash return of Alice’s property. All we need to do is determine the total cash flow divided by the total cash invested from above:
$8,000 / $102,000 = 7.84%
That’s all there is to it. For the year in question, Alice’s cash-on-cash return rate for that property was a little below 8%.
What is a Good Cash-on-Cash Return?
As with practically any investment calculation, there are too many variables to lay down a hard-and-fast rule about what makes an ideal cash-on-cash return.
Markets and time will both play a significant role in a property’s cash yield, as will various factors of your specific investment setup, such as:
- Whether or not you bought or sold the property during the year in question
- Your out-of-pocket spending
- Any reinvestment of income back into the property
- How much risk the investment carries
- The type and amount of leverage on the property, if any
Depending on these factors and many others, the benchmark for a good cash-on-cash return can fluctuate.
To put a number on it, many investors suggest that a return between 8 and 12 percent is a good target. However, it is possible to hit a yield lower than this and still have an excellent investment return.
Remember, there are many variables; this is just one calculation you can use to help guide your property investing decisions. For your portfolio strategy to be most effective, it will always be best to consider multiple metrics and figures and build a broader profitability picture than you can gain from analyzing only one.
Cash-on-Cash Return vs. ROI
At a glance, cash-on-cash return is a seemingly identical metric to standard return on investment (ROI). Indeed, the two are pretty similar ways of measuring the profitability of an investment property, but each serves a unique purpose.
The primary difference between ROI and cash-on-cash return is the role of debt in the equation. The ROI on a property includes the total debt involved when calculating performance. On the other hand, cash-on-cash only considers the cash the investor put in.
Therefore, debt only affects cash-on-cash return insofar as the investor makes debt payments on the property in the year in question.
ROI signals how well an investment performed overall, while cash-on-cash more specifically indicates how it performed with the investor’s cash.
Cash-on-Cash Return vs. Internal Rate of Return (IRR)
While cash-on-cash return looks at the past success of an investment and offers some help in forecasting future results, the internal rate of return (IRR) looks primarily to the future. Put simply, IRR predicts the annual growth rate that an investment could generate.
IRR provides an estimate of the profitability of an investment and is one of the metrics investors can use to decide whether to pursue a particular opportunity. However, because future projections are involved, the calculation is a bit more complex than cash-on-cash return.
In essence, the IRR calculation projects the cash flow with the time value of money and estimates a return rate for the investment.
Building Out Your Investing Metrics Toolbox
Cash-on-cash return is an essential metric for gauging the profitability of an investment property. It is straightforward to calculate and boils down to the health of your investment based on the simple elegance of cash in vs. cash out.
However, this simplicity is also where cash-on-cash return may struggle to give you a cohesive picture of your investment on its own. It works best alongside other investment property vital signs like the internal rate of return (IRR), net operating income (NOI), and capitalization rate (cap rate).
An investor’s toolbox needs many tools, and cash-on-cash return is one of the absolute essentials. Understanding a property’s past and potential cash yield can help you make more accurate forecasts and decisions, ultimately bringing you to a healthier, more thriving portfolio.