If you are considering investing in the US housing market 2020, then it is important that you understand the concept of cash on cash return and what a good cash on cash return means for a rental property.
In the world of real estate investing, the goal of every real estate investor is to find income producing rental properties. For this reason, it is important for you to assess the profitability of properties before investing your money in them. You can do so by conducting a rental property analysis, which will help you analyze a rental property’s return on investment (ROI). A key metric in the return on investment analysis of a real estate investment is the cash on cash (CoC) return. So let’s start off by explaining what CoC return is exactly.
What Is Cash on Cash Return?
Also known as the equity dividend rate, the cash on cash return is a measurement of the net income generated by a rental property, relative to the initial cash investment that was made to buy that property. In other words, it tells you how much money you’re earning back each year if you put a certain amount of money down. Real estate investors sometimes call this method of determining the return on investment “the cash flow yield”. In order to know how to calculate cash on cash return, let’s have a look at the cash on cash return formula.
The Cash on Cash Return Formula
The cash on cash return formula seems pretty simple. The CoC return is calculated by dividing the net operating income by the total cash investment.
The Net Operating Income (NOI) is the annual amount of money that your rental property generates, minus all the operating expenses.
i.e. Net Operating Income = Annual Rental income – Operating Expenses
The Total Cash Investment is all the cash that you need to pay to make the investment property operational. This includes the amount of money that you pay to buy the property, closing costs, rehab costs, and loan fees (if you take out a mortgage loan).
i.e. Total Cash Investment = Down Payment + Closing Costs + Repairs
As you can see, the CoC return on an income property will vary depending on your financing method, i.e. whether you take out a loan or pay the full price in cash. To have a better understanding of this, let’s use an example to demonstrate how to determine cash on cash return for each scenario.
Related: Cash on Cash Return Calculation in Real Estate: What to Include
Example #1: All-Cash Investment
Let’s suppose you want to purchase a rental property that costs $300,000 and you are able to pay the full price in cash. You would also need to pay, let’s say, 5% in closing and rehab costs, so this adds up to $15,000 in additional costs. Therefore:
Total Cash Investment = $300,000 + $15,000 = $315,000
Now, regarding the Net Operating Income (NOI) calculation, let’s say you charge $3,000 for rent per month. So your annual rental income would be: 12 x $3,000 = $36,000. Let’s also assume that you would be spending a third of your rental income on operating expenses, i.e. $12,000, so you are left with an NOI equal to:
Net Operating Income = $36,000 – $12,000 = $24,000
Now that we have all the variables of the formula, we can finally calculate the CoC return:
CoC Return = $24,000 / $315,000
CoC Return = 7.6%
This means that the CoC return which you will generate from this rental property investment if you opt for an all-cash investment is 7.6%.
Example #2: Mortgage Loan Investment
Now, let’s be real. Not all of us can afford to pay the full price of an investment property in cash. So, for this example, let’s assume that you are purchasing the rental property using a mortgage loan, which is a more realistic scenario. In this case, the CoC return will be calculated in a slightly different way. Let’s see how it compares with the previous case (i.e. without a loan) and what final value we will get.
Related: What Kind of Mortgage Options Are Best for Rental Properties?
Let’s say you put a down payment of 20% in cash to buy the same $300,000 rental property as in the previous example. So, you would pay 20% x $300,000 = $60,000 as down payment. You would also need to pay the closing and rehab costs of 5%, adding up to $15,000 in additional costs. Therefore, the total cash investment in this case would be:
Total Cash Investment = $60,000 + $15,000 = $75,000
When it comes to calculating the NOI, you need to take into account another factor: the debt service of the loan. Remember that you are taking out a loan for 80% of the property price, which equals an amount of $240,000. Assuming the interest rate on the loan is 9%, we get a debt service of 9% x $240,000 = $21,600. Therefore, the NOI would be:
NOI = $24,000 (Annual Rental Income minus Operating Expenses) – $21,600 (Debt Service)
NOI = $2,400
So, the CoC return for this real estate investment would be:
CoC Return = $2,400 / $75,000
CoC Return = 3.2%
This means that the CoC return which you will generate from this rental property if you take out a mortgage loan for 80% of the price is 3.2%.
As you may have noticed, the cash on cash return dropped when purchasing the rental property using a mortgage loan. Note that this is not always the case. There are some cases where taking a loan can actually increase the CoC return. It all depends on the values of the different costs, such as the property price, the loan amount, the interest rate, the expected rental income, etc.
The Cash on Cash Return Calculator
Calculating cash on cash return can sometimes be time-consuming and require a lot of effort – not to mention that we are prone to making errors when carrying out such lengthy calculations. But there’s no need to worry! No one expects you to calculate CoC return manually. You can simply use a cash on cash return calculator.
Related: Should You Let a Cash on Cash Return Calculator Make Investment Decisions for You?
Mashvisor’s cash on cash return calculator – which is a part of Mashvisor’s rental property calculator – can help you compute the CoC return of a rental property and its rate of return on investment, in a quick and accurate way. It also calculates the cap rate and cash flow as well. All you need to do is to simply input all the necessary costs. An interesting feature is that the calculator gives you all this data for your property as a traditional investment or Airbnb investment.
The CoC return calculator is a must for all real estate investors looking to succeed in the US housing market 2020. To learn more about our product, click here.
What Is a Good Cash on Cash Return?
For those wondering what is a good cash on cash return for a rental property, we can tell you this: there isn’t a specific rule of thumb. Some real estate investors consider that anything between 8-12% makes for a good return on investment. Meanwhile, others will not even think about buying a rental property if it doesn’t generate a CoC return of at least 20%.
Looking at the housing predictions for the US real estate market 2020, the values mentioned above seem quite hard to reach. Don’t forget that we are talking about a broad and ever-changing market, and so the cash on cash ratio for a rental property could vary significantly depending on several factors such as the property type (condo, single family home, multi family home) and its location.
So, if you are a beginner investor, it is recommended that you start looking for rental properties using a cash on cash return calculator so that you can find high CoC return properties more easily.
However, keep in mind that the CoC return does not tell you everything about a rental property. For instance, it does not take into account real estate appreciation or tax benefits. The cash on cash return calculation allows you only to figure out whether a rental property investment will be a good idea or not. So, don’t rely on it solely when evaluating the performance of an investment property, but always make sure to use several metrics.
To start looking for and analyzing the best cash on cash return real estate properties for sale, click here.