Profitability metrics are perhaps the sole significant aspect of buying an investment property that generates profits. The one that we must highlight, though, is the cash on cash return.
This post is meant to provide real estate investors with the most important facts about the cash on cash return.
Related: The Cash on Cash Return Calculator: The Ultimate Real Estate Investing Tool!
What is cash on cash return?
The cash on cash return is a common way to calculate the yields of an income property based on what a real estate investor has invested in the first place. In other terms, the cash on cash return is a form of measuring the return on investment. Here is an example:
Suppose you are buying a rental property that is worth $120,000. You choose a mortgage as a method of financing for the investment property. You are required to pay a 20% down payment ($20,000) in cash. The cash on cash return would be the rate of return based on the $20,000 you have actually invested regardless of the rest.
How to calculate cash on cash return
The cash on cash return formula is pretty simple. However, there are a few measures that are involved that we feel that we must explain. Afterward, we are going to present cash on cash return in action to actually show you how to calculate it.
The cash on cash return formula:
Cash on cash return = Net Operating Income (annual cash flow) / Equity * 100%
Now, to break it down for you here is what each variable means:
Net Operating Income (NOI):
The net operating income is the annual cash flow an income property generates. If you get a positive cash flow each month, this means that you are making money in real estate. However, to calculate the cash flow, you deduct monthly rental expenses from your monthly rental income. These expenses include mortgage payments, electricity, any repairs paid for and so on.
Thus, to calculate the annual cash flow (the NOI), you can simply multiply the monthly cash flow by 12. Having said that, the problem with this calculation method is that the cash flow is a variable. It might not be the same amount for every month depending on the expenses. For example, one month you will find yourself free of any expenses other than the expected ones such as the mortgage payment. While in other months, you might have a situation that requires you to repair some broken item or facility around your rental property. This, of course, will cause your cash flow to be unstable from month to month.
In this case, it is always a better idea to add up the amounts of cash flow your income property generated throughout the year month by month. In this way, you can make sure you are having a precise calculation of that property.
Well, the question is, what if you still haven’t purchased the property? How do you know how much rental income you are to expect? The answer is, either with a home appraisal or through your real estate agent. All in all, it all comes down to the investment property analysis process which evaluates the rental potential of a rental property.
Related: What Are the Best Ways for Financing Investment Properties?
To explain it in simple terms, equity in real estate is the difference between the property price and the amount of money you owe your mortgage lenders. For instance, if your property is worth $200,000 and you still have $70,000 to pay for the mortgage lender, your equity is worth $130,000. To calculate it, you basically deduct the amount of mortgage you still owe from the overall property price.
Keep in mind, equity is also the down payment you have paid for the property. So, it doesn’t have to be that you have started paying the mortgage payments. It can also be the amount of money you have put into the deal throughout the process of closing. If we take the previous example of equity, suppose that you did not start making mortgage payments yet. However, when you applied for the mortgage, you were asked to pay 20% as an initial payment. This means that you have actually invested $20,000 into the property. This also means that you have built an equity of $20,000 over the property.
An example of Cash on Cash return calculation:
Considering the facts above, here is an example that involves all the previous variables of the cash on cash return formula:
Robert is a property investor. He is considering buying a rental property that is worth $350,000. Robert has only $100,000 in cash so he applies for a mortgage to cover for the rest of the amount he needs to purchase that property. While the mortgage lender requires that Robert pays 20% in down payment, Robert has more to pay, so he does.
As Robert started to perform the investment property analysis, he realized that it has the potential of renting at $1500 a month. Hence, he expects to pay $600 a month for the mortgage lender, a $100 in insurance and leave out $300 for other expected and unexpected costs. As he closed the deal and let tenants into the property, Robert used the $300 budget twice in the first year. So, based on the previous data, what is the cash on cash return of this rental property?
First, we start with the NOI (the annual cash flow).
Annual Cash flow = Annual rental income ($1500*12) – Annual expenses (($600 + $100) *12 + $300*2)
Annual Cash flow = $18,000 – $9000 = $9000 (excluding taxes)
Now that we are done with the NOI, let us calculate the equity that Robert has over the property. Considering the property price, Robert got financing worth $250,000. This means that he owns $100,000 in equity over this particular property. Therefore, this leaves us with the simple cash on cash return formula of:
CoC return = NOI ($9000) / Equity ($100,000) * 100% = 9%
What is a good cash on cash return for the best real estate investments?
Generally speaking a good cash on cash return rate would be anywhere from 8% and above. Some investors won’t even bother investing in a property that has a CoC return rate of less than 20%. So really, it all depends on what an investor is looking for.
Hence, for the best real estate investments, you must not rely on one profitability metric. The cash on cash return alone is not a solid indicator. Even though it is an easy way to get a glance at what you are getting into, it is not definite. Using other metrics along with the CoC return would be a better idea. For example, use the capitalization rate. This metric is similar to the CoC. However, instead of dividing the NOI by the equity, you divide it by the overall property price.
Related: How to Calculate Cap Rate for Rental Properties Most Efficiently
The reason we say that you must use a variety of profitability metrics along with the cash on cash return is that it leaves out taxes as well as any appreciation or depreciation rates. This makes it a bit shaky in terms of accuracy.
Last but not least, to enjoy a rewarding real estate investing journey, make sure you subscribe to Mashvisor and consult with our best real estate professionals!