When you’re starting a career as a real estate investor, one of the most common terms that you’ll hear is cash on cash return. In the world of real estate investing, it’s essential for property investors to evaluate the profitability of investment properties before investing their money in them. Doing so will help the real estate investor find the best positive cash flow investment properties and avoid the negative cash flow ones.
For this very reason, before committing to a real estate investment, property investors have to perform a real estate market analysis in addition to an investment property analysis in order to find the best profitable investment properties with high return on investment. One of the most commonly used metrics that a real estate investor should always keep in mind to determine the profitability and return on investment is the cash on cash return.
In this article, we will go over various aspects of cash on cash return so you can get the best understanding possible. We will answer questions like what is cash on cash return, what makes it different from the cap rate metric, how to calculate cash on cash return, and more!
What is Cash on Cash Return in Real Estate Investing?
In simple words, the cash on cash return is the rate of return on investment that a real estate investor will earn on a real estate investment based on the profit that a rental property makes and the amount of cash actually invested in the rental property. In other words, cash on cash return shows property investors a percentage of the profits they should expect with regards to how much cash they actually invested. But what is the benefit of this?
In real estate investing, the return on investment that property investors receive depends on how they finance the investment properties. One real estate investor might be able to finance the purchase of an income property fully in cash, while another might not have enough capital and thus will have to take a mortgage loan and pay a down payment (usually 20% of the rental property’s purchase price). A mortgage is actually the most common investment property financing method, however, is it the best option for a high return on investment? Calculating the cash on cash return will give you the answer.
For example, say you want to buy a rental property and you’re wondering which financing method will give you the best return on investment. 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 to decide the best way to finance the rental property!
What Makes Cash on Cash Return Different From Cap Rate?
Another popular metric in real estate investing to measure profitability and the return on investment is the cap rate. The difference between these two metrics is the financing costs – these are not included in the calculation of cap rate, but, as mentioned earlier, they are included as an expense when calculating the cash on cash return. Moreover, the cap rate is closely related to risk in real estate investing – higher cap rates correspond to a higher level of risk and the opposite holds true. The cash on cash return, on the other hand, is only used to forecast potential profits over the life of the investment.
What this means is that cash on cash return, unlike cap rate, analyzes and measures the profitability of an income property taking into consideration the investment property financing method, while cap rate measures the profitability and return on investment 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 the Cash on Cash Return of an Investment Property
The cash on cash return is calculated by dividing the net operating income (before tax) by the amount of total cash actually invested.
CoC Return = Net Operating Income/Total Cash Investment
The net operating income (NOI) is the annual rental income minus the operating expenses, and the total cash investment is all the cash that property investors have to pay in order to make the income property operational. This includes the amount of money to pay to purchase it, closing costs, rehab costs, and mortgage loan fees (if you take a mortgage from the bank). To make this clearer, let’s calculate the cash on cash return for an investment property financed with all cash vs. a mortgage:
Financing the Investment Property with All Cash
Let’s say you’re thinking of buying a $250,000 rental property and you’re able to finance the purchase fully in cash. Assume that closing and rehab costs add up to $12,500, and you’re renting out the rental property for $2,100 per month. Thus, your total cash investment is $262,500 and your annual rental income is $25,200. Let’s estimate the NOI at a third of the rental income, leaving you with $16,800.
CoC Return = NOI/total cash investment = $16,800/$262,500 = 6.4%
This means that if you paid for this income property fully in cash, you’ll generate a 6.4% cash on cash return.
Financing the Investment Property with a Mortgage
Now let’s face it – not every real estate investor can pay $262,500 out of their pockets to finance the purchase of an income property. This is why most property investors opt for a mortgage loan as the best investment property financing method. Let’s consider the same $250,000 income property and compare the cash on cash return!
So, a real estate investor is buying a $250,000 investment property and pays 25% in cash as a down payment (25% x $250,000 = $62,500). Including the same additional $12,500 for closing and rehab costs, the total cash investment will equal $75,000.
Remember: do not include the bank loan and only the 25% down payment!
Now, to calculate the NOI, we have to add the debt service (the cash required to cover the repayment of interest and principal) to the equation. Assuming an 8% interest loan, debt service will equal $15,000. Thus, the NOI is $16,800 – $15,000 = $1,800
CoC Return = NOI/Total Cash Investment = $1,800/$75,000 = 2.4%
This means that the cash on cash return which the real estate investor will generate from this income property if he/she took a mortgage loan for 75% of the price is 2.4%.
Keep in mind that just because in our example the cash on cash return dropped significantly with a mortgage loan, it doesn’t mean that this will always happen! Sometimes, taking a mortgage can actually increase the cash on cash return. It all depends on the price, the loan amount, the expected monthly rent, etc.
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What is a Good Cash on Cash Return in Real Estate Investing?
Experts in the real estate investing business still disagree on the numbers. Some say anything in the range of 8-12% of cash on cash return makes a good return on investment. On the other hand, others would not recommend buying the investment property if it doesn’t generate a 20% cash on cash return.
However, to determine whether your cash on cash return is good or not, you need to keep some factors in mind, the first of which is obviously the investment property financing method. Other factors that affect the cash on cash return of an income property include the type of the investment property and its location.
Mashvisor’s Cash on Cash Return Calculator
If you’re looking for a real estate investing tool to make cash on cash return calculations on an income property much easier, we’ve got your back! Mashvisor’s cash on cash return calculator – a part of Mashvisor’s rental property calculator – not only allows you to compute the cash on cash return on a rental property, but it also gives you access to readily available and accurate cash on cash return data for thousands of investment properties across the US real estate market – both traditional and Airbnb!
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Final Words on The Cash on Cash Return
To sum up, cash on cash return in real estate investing is a metric used to measure the profitability of investment properties taking into account the financing method. This helps property investors determine the best way to finance the purchase of investment properties for the best return on investment.
To calculate cash on cash return on a rental property, property investors use the above-mentioned formula or, alternatively, make use of Mashvisor’s rental property calculator to easily identify investment properties with the highest potential for profits across the US real estate market! To learn more about our product, click here.
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