Every real estate investor has heard of the term cash on cash return at one point or another and knows how important it is to calculate it. In real estate, it is crucial for investors to evaluate the investment property before investing their money into it. You need to know what you’re getting out of the investment property compared to what you are putting into it. That is why real estate investors need to do an analysis of the property and identify its return on investment. For this reason, the cash on cash return formula is used.
What is cash on cash return?
Let us first clarify what cash on cash return actually means. The cash on cash rate of return measures the ratio between the total amount of cash flow a rental income property generates in a particular year and the total cash investment a real estate investor initially makes to purchase the investment property. In other words, cash on cash return is calculated because it shows the yield an investor might expect to collect on his or her cash investment. The cash on cash return is a ratio based on the annual cash flow divided by the equity you have invested in the property. The formula is:
CoC = Cash Flow / Invested Equity
The return on investment that real estate investors receive mainly depends on the way they finance the property. Some investors may pay for the property with full cash while others are required to take a mortgage loan. Many investors can’t decide which financing method is best for a high return on investment. Should they use their cash to invest in the property or apply for a mortgage loan? In a situation such as this, calculating the cash on cash return will give you the best option. How? The cash on cash return metric will allow you to calculate and compare the rate of return on investment for both options which makes it easier for you to decide.
What is a good cash on cash return in real estate investing?
Of course, this is waaaay too broad of a question. This question doesn’t have a concrete answer that you can just stick to. It really depends where you are in the country and what property type you are hunting for. Every real estate expert is different from the other on how they define a good cash on cash return. Some would agree that anything above 8% is good while others would not even think about a rental property if it doesn’t give them a cash on cash return of 20%. So it all comes down to how you look at the situation you are in.
Of course, one thing to keep in mind is that cash on cash return doesn’t take into account any tax income effects, resale implications, future cash flows or reductions in loan principal. It does, however, give a good feel for the immediate and ongoing periodic return that a cash flow investor can expect. The cash on cash return formula can also show the effects of leverage using a mortgage loan to finance part of the property’s purchase price. All in all, determining whether or not your investment property will have a good cash on cash return is considered through many factors.
Cap rate vs. Cash on cash
Some may confuse the difference between cap rate and cash and cash return. The difference between them is the financing costs which are not included when calculating the cap rate. Cash on cash measures the returns a particular investment is expected to make and the profitability of an income property. On the contrary, cap rate measures the risk level of a certain property. Higher cap rates correspond to a higher level of risk and the opposite holds true. Cap rate measures the profitability of the property with regards to the purchase price of the rental property and the level of associated risks.
Related: Cap Rate vs. Cash on Cash Return
How to calculate cash on cash return
Calculating cash on cash return is not a difficult task. In order to calculate your cash on cash return, you need two figures:
- The actual cash you invested in buying the property
- The annual cash flow you can get out of the property
As always, calculating the expenses is the hardest part and the one that needs the most concentration. Not only because it can be easy to forget about certain expenses, but others are simply unknown for certain and you need to estimate these such as taxes, maintenance costs, property management, vacancy, and mortgage. In order to calculate the cash on cash return, you need to divide the annual cash flow by the actual cash invested without the mortgage.
The bottom line
Calculating the cash on cash return for an investment property can help you a lot in deciding whether or not the property is worth putting your time and money into. That is why every real estate investor should be aware of what cash on cash return is and how it is calculated to make smarter real estate decisions.
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