As a real estate investor, you have definitely come across the term cash on cash return. Though it sounds simple, many real estate investors and even real estate agents misunderstand it.
In this article, we are going to break it down for you. We are going to answer the most important and most frequent questions related to cash on cash return including the following:
- What is cash on cash return?
- What factors affect it?
- Why is it a good metric in real estate analysis?
- Why is it a bad metric in real estate analysis?
So, hang on and find out the answers!
Related: How Can You Plan for the Best Cash on Cash Return?
First: What is cash on cash return?
Cash on cash return is a metric used in real estate to calculate the percentage of your annual income from your investment property. Notice here that we said it is a percentage, which means that you are not dealing with specific numbers.
So, here is the formula for which it is calculated:
Cash on cash return = pre-tax cash flow/the actual cash invested in the property
So, in order for you to get a better understanding of how it works, we are going to break it down as much as possible. First, we are going to talk about the pre-tax cash flow, and then we are going to talk about the cash invested in the property.
The pre-tax cash flow:
When we say pre-tax cash flow, we are talking about annual cash flow, so pay attention to that. Here is the formula with which it is calculated:
Pre-tax cash flow = gross rent + extra income – vacancy – operating expenses – annual debt service
So, let us go over each part of the equation in detail:
Gross rent: This indicates the rental income you are expected to receive annually. It is calculated by multiplying your monthly charged rent by 12.
Extra income: This is, in fact, a variable. It does not apply to all properties. It only applies if you are charging any extras on utilities for your rental property. For example, you could be renting out the garage separately or even the basement maybe. So, make sure to calculate that as an annual average.
Vacancy: Calculate any days during which your rental property was vacant and multiply that by the daily rent. Then you should subtract that from the gross rent + the extra income.
Operating expenses: The operating expenses on your rental property include taxes, insurance, repair and maintenance, and property management expenses. However, they do not include depreciation rates.
Annual debt service: This includes the interest you pay related to your loan.
The actual cash invested in the property:
The cash invested in your investment property is calculated as follows:
Cash invested = down payment + closing costs + pre-rent repairs
Now, let us also break these down.
Down payment: This is the amount of money your lender requires you to pay to obtain the property.
Closing costs: Simply, you sum up all the money you have paid to acquire the property excluding the down payment. Then subtract any cash you got from your lender.
Pre-rent repairs: These expenses include any cash you have put into repairs, maintenance, or even adding improvements before renting your property.
Keep in mind that when you are calculating the cash on cash return, you should subtract any expenses you have paid on the rental property. This is important in order to get an accurate percentage of the actual cash flow your rental property is generating.
Second: What factors affect cash on cash return?
You must understand that the cash on cash return is not a stable metric. It is influenced by factors such as the rental property’s location, type, and maintenance. For instance, if your property has suffered a severe damage for some reason this year, then you should expect less cash on cash return than last year. Location is another factor. Let’s suppose that your rental property is located in an area that depends on a specific industry employment. Suppose this employment market has weakened, then your property is going to suffer as well resulting in less cash on cash return that specific year. On the contrary, suppose that the area experienced a rise in rent for whatever reason, then your cash on cash return will go up as well.
Still, you have to keep in mind that ash on cash return does not get influenced by appreciation. Appreciation only applies and is calculated at the moment you sell your property. So, it does not have anything to do with the cash on cash return.
Related: The 10 Top Profitable Locations for Traditional Rentals in the US Housing Market at the End of 2017: Cash on Cash Return
Third: Why is cash on cash return a good metric in real estate analysis?
First of all, most real estate investors and real estate agents prefer to use this metric due to its simplicity. It is simple and easy to use compared to other real estate metrics. Moreover, it helps them know the approximate cash flow a certain rental property is generating or will generate. Therefore, it helps at times when deciding whether a certain property is worth investing in or not.
Fourth: Why is cash on cash return a bad metric in real estate analysis?
The downside of cash on cash return analysis is that it does not give accurate numbers. By that we mean that it is solely a percentage that is greatly influenced by other factors, for instance, taxes. Yes, you have to take that into consideration as well as the loan payments and interest. The cash on cash return you get this year does not have to be the same as the previous or the next one. So, keep that in mind and lower your expectations.
Related: Calculate Cash on Cash Return Without a Property Calculator
Cash on cash return in one of the most used terms in real estate analysis by investors, agents, and even others. So, understanding what it is and what it does for you is important. It will help you deal with the basic calculations associated with your investment property. Although you do not need to do complex calculations, knowing the basics is a must.
Here on Mashvisor we provide you with up-to-date data on cash on cash return on all the properties listed on our website. All you have to do is click on the property, and you will have all the investment property analysis associated with it.