Cash on cash return can tell an investment property’s profitability. Knowing the cash on cash return formula can help you make the right decision.
Table of Contents
- What Is Cash on Cash Return?
- How to Calculate Cash on Cash Return
- What Is a Good Cash on Cash Return?
- Cash on Cash Return vs Cap Rate
- Cash on Cash Return vs Return on Investment
- Why Is Cash on Cash Return Important in Real Estate?
- Do You Need a Cash on Cash Return Calculator?
With the current demand for housing as Americans move from one state to another, real estate experts believe buying a rental property will make a good investment in 2022. Despite the global crisis due to the ongoing pandemic, the real estate market still thrives and continues to grow.
While new economic uncertainties emerge because of the current global problems that we are facing this year, we cannot deny the fact that people still need a place to stay. However, not everyone can afford to buy a home. It is why real estate investors should take advantage of the demand for housing by investing in rental income properties for sale.
It should be noted that not all properties can provide investors with the same opportunities and profitability. Before you start a rental property business, it’s crucial to carefully choose which properties to invest in and do your research comprehensively. It is to ensure that you’re making the right investment decision. Aside from making sure that you’re investing in a good location, you also need to check several metrics to establish the potential returns of a property.
Several factors can determine whether or not a particular investment property will become a good investment. Experts use various measures to check the profitability of an income property before actually buying it, and one of these measures is the cash on cash return.
What Is Cash on Cash Return?
Cash on cash return is a rate of measure that determines how much returns you can expect from an income property based on the amount of cash you invested. The CoC return is calculated before tax is deducted. Some investors calculate the figure manually using the cash on cash return formula, while others use a cash on cash return calculator for easy and quick computation.
The value of cash on cash return will depend on whether you will purchase the property entirely in cash or through a mortgage. If you plan to take a loan to purchase the property, the cash on cash return will only be based on the amount of your cash investment.
It includes your cash down payment, closing costs, and other expenses that you’ll pay for in cash, such as appraisal fees and costs of repair. It does not include the loan amount that you borrowed from the lender.
Investors use cash on cash return to weigh the cash flows generated from an investment property in order to determine the annual cash return. Moreover, cash on cash return is used to compare the cash you receive from cash flowing assets on a monthly or yearly basis versus the cash invested. The cash on cash return is typically expressed as a percentage.
Related: What Cash on Cash Return by City Should Real Estate Investors Expect in 2022?
How to Calculate Cash on Cash Return
In order to calculate the cash on cash return, first, you need to determine the annual pre-tax cash flow generated from the rental property investment. Then, you need to figure out whether you want to buy the property in cash or you will take a loan to fund the purchase. You need to determine the amount of cash that you will invest in the property. It is not limited to the purchase price but should include all other expenses that you will pay for in cash.
If you plan to calculate the cash and cash return of an investment property manually, you can use the following cash on cash return formula:
Cash on Cash Return = (Annual Pre-Tax Cash Flow / Total Cash Invested) x 100
The pre-tax cash flow is the annual amount of rent an income property generates. To get the annual pre-tax cash flow, you need to deduct the mortgage costs from the annual net operating income, as shown in the following formula:
Annual Pre-Tax Cash Flow = Annual Net Operating Income – Mortgage Costs
Your total cash invested should include your cash down payment, loan closing costs, and rehab costs (if you did some repairs on the property). Also, include other expenses that you paid for in cash, such as inspection fees and appraisal fees. You can use the following formula:
Total Cash Invested = Down Payment + Closing Costs + Rehab Costs + Other Expenses Paid in Cash
After dividing the annual pre-tax cash flow by the total amount of cash invested, multiply the quotient by 100 to convert it to a percentage. That is your rate of cash on cash return.
Sample Manual Calculation Using the Cash on Cash Return Formula
For example, an STR real estate investment property earns an annual rental income of $80,000. The annual mortgage payment is $60,000. So, your annual pre-tax cash flow is $80,000 less $60,000, which is equal to $20,000.
The total cash invested includes the down payment for the property ($250,000), and other expenses like closing costs, repair costs, and initial property management fees (total of $25,000). For our example here, our total cash invested is $275,000.
Using the cash on cash return formula above, the cash on cash return for our example is computed as follows:
CoC Return = ($20,000 / $275,000) x 100 = 7.27%
Based on our example, the cash on cash return of the short term rental investment property is 7.27%. But as beginner investors, how do we know if the property is worth investing in? How do we know if the said rate is considered a good cash on cash return?
Related: The Best Cash on Cash Return Calculator in 2022
What Is a Good Cash on Cash Return?
We’ve learned how to compute a property’s cash on cash return based on the manual cash on cash return formula stated above. However, knowing the formula and how to calculate the cash on cash return is not enough to decide whether or not a property would make a profitable investment. More importantly, we need to know what range of cash on cash return rates are considered good for investing.
Generally speaking, what makes a cash on cash return “good” is subjective—a good rate can vary from one investor to another. However, many seasoned real estate investors would agree that a rate of 8% or higher is what’s accepted as a “good” cash on cash return. Nevertheless, the figure is not set in stone.
A good cash on cash return will also depend on the location of your investment property and how the rental market performs. In some real estate markets, a cash on cash return of around 3% to 4% is considered justifiable. On the other hand, in some locations, investors will only be satisfied with a cash on cash return of at least 10% or higher.
Cash on Cash Return vs Cap Rate
Both the cash on cash return and cap rate are important metrics to analyze the profitability and income potential of a rental property. However, the cash on cash return formula is different from the formula used to calculate a property’s cap rate.
Below are the significant factors that define the difference between cash on cash return vs cap rate:
- Financing costs: Cap rate does not take into consideration how a property is financed. While the loan closing costs are included with the cash on cash return formula, they are excluded from the calculation of the cap rate. Because the cap rate does not include the financing costs of a property, you can better compare similar properties or rental comps in the same area.
- Equation: The equation used for the cap rate formula is different from the one used for the cash on cash return formula. To compute the cap rate, you need to divide the net operating income by the property’s market value or purchase price. On the other hand, cash on cash return takes into account the amount of cash invested instead of the price of the property.
Keep in mind that if you are investing in cash entirely, the value for both cash and cash return and cap rate will be the same. Usually, most investors who plan to take a loan use the cash on cash return formula to measure the rate of return on an income property. On the other hand, investors who plan to invest in cash entirely analyze the real estate ROI using the cap rate metric.
Investors need to compare similar properties or do rental comps when using the cap rate formula, which excludes the property’s financing costs.
Cash on Cash Return vs Return on Investment
In real estate investing, the return on investment (ROI) indicates the overall profitability of a rental property. When you compute the ROI of an income property, you will determine the total gain (or loss) the property will generate over the entire period that you own the asset. In contrast, the cash on cash return shows an overview of the annual cash flow real estate.
Another difference between the ROI and cash on cash return is that the former is cumulative, while the latter is not. Furthermore, when you calculate the return on investment of a property, it takes into consideration all the debt associated with the property. It includes the mortgage used to acquire the property and any future additional loans for capital. On the other hand, cash on cash return only includes the computation of the money you currently owe.
Related: What Is a Good Return on Investment for a Rental Property?
Why Is Cash on Cash Return Important in Real Estate?
Cash on cash return can predict how an income property might perform over time. It is an essential tool used by investors to figure out the potential cash flow investments for a specific property. If you are comparing multiple rental properties and can not decide which one will make the best investment, using the cash on cash return metric can be very helpful.
The CoC return is most useful if you plan to purchase the property through a mortgage loan. The value of the CoC return will vary depending on the amount of cash you invested and the amount of amortization you need to pay every year. As a result, cash on cash return is a useful metric for helping you establish how much cash to invest or how much loan to take out.
Do You Need a Cash on Cash Return Calculator?
A cash on cash return calculator is an important investment tool that can automatically calculate the cash on cash return rate of an investment property. It can be done without the need for manual computation using the cash on cash return formula. Manual computation can lead to errors, and it can significantly affect your investment decision.
The good news is that there are several cash on cash return calculators available online. However, most free investment property calculators do not provide the necessary information that you need to get an accurate result. For a successful investment, what you really need is an all-in-one rental property investment calculator that does not only compute the cash on cash return.
The best investment property calculator also calculates other important metrics to help you make an informed investment decision. The metrics should also include the cap rate and return on investment. In addition, the best rental property calculator can also calculate financing details, such as your monthly amortization based on your chosen loan terms.
Additionally, you should find an investment property calculator that can automatically provide all the necessary information, such as rental income and expenses. For instance, the calculator should be included in a property listing database, so you can immediately see how much cash on cash return a particular property will generate. In such a way, you wouldn’t need to do your own research to find the important details needed in the cash on cash return formula.
When you are ready to take advantage of the higher demand for rent and the rising rental prices, make sure to check the cash on cash return of an investment property. Use it to compare similar properties and decide which one will make the best investment. Mashvisor’s rental property calculator provides all the necessary data for you.
Schedule a demo now to see how it works and how it can help you meet your investing goals.