Cash on Cash Return on Investment

When analyzing real estate deals, one of your biggest concerns should be the rate of return (also known as return on investment or ROI). What is the percentage return on the capital invested? One metric many real estate investors like to use is Cash on Cash Return on Investment (CoCRoI). It is the amount of cash flow you receive relative to the amount of money you pay out-of-pocket for the property.

CoCRoI = Pretax Annual Cash Flow / Cash Out-of-Pocket

If you have had an interest savings account and/or investing in the stock market (such as holding dividend yielding stocks and interest yielding bonds), you might be familiar with CoCRoI. For instance, if you invest $1,000 in a stock that pays out $30 in annual dividends, your CoCRoI on that $1,000 is 3% of your capital invested. Likewise, if you pay $1,000 cash out-of-pocket to acquire a property that generates $50 in cash flow annually, your CoCRoI yield is 5%.

Being able to draw this parallel across different investments (or asset classes) is pretty cool, right? You can easily compare rates of return on rental property investing to lending and investing in the stock market. Knowing that the stock market historically returns 7% to 8% annually, is a Cash on Cash Return yield of 6% on an investment property a good return (keep in mind that different asset classes have different levels of risk and CoCRoI doesn’t account for relative risk factors)? As a newbie real estate investor (but a somewhat seasoned stock market investor), I certainly appreciate this familiarity.

Factors that Can Influence the Cash on Cash Return Yield

Now that we’ve got down some basics on Cash and Cash Return and how you might want to use this metric, let’s take a closer look at the formula applied to real estate investing.

CoCRoI = Pretax Annual Cash Flow / Cash You Put Down on the Investment

where,

Annual Cash Flow = Projected Rent + Michellaneous Income (such as parking space monthly rent and nonrefundable pet deposits) – Average Vacancy Rate for the Area – Operating Expenses – Mortgage Payments

Cash You Put Down on the Investment (also known as investment basis) = Down Payment + Closing Costs + Repairs (or Improvements)

Cash Flow = Gross Income – Expenses – Mortgage Payment

Accordingly, if you want to increase the CoCRoI yield, you can either increase the annual cash flow or minimize the cash you put down on the investment property.

Knowing about this, you might be tempted to only pursue potentials deals that generate large cash flows. Make sure you do your due diligence. Is the property in a good neighborhood with excellent amenities? Investors tend to charge relatively higher rents on properties located in less desirable neighborhoods (when expressed as a percentage of property acquisition price). Is this the kind of neighborhood you want to invest your money in? Does the property have a number of expensive deferred maintenance issues? If this is the case, the cash flow number might be inflated. When expenses are high, the return on cash flow decreases (refer to Cash Flow formula).

How to go about increasing cash flow? You can do rehabs or repairs on the property. You can also improve on the property by putting in new appliances, lamp fixtures, a new coat of paint, new flooring, new windows, just to name a few.

Next, let’s look at investment basis, the other factor influencing the Cash on Cash Return. It’s been said that real estate investing is one asset class where investors can use big leverage. What this generally means is that you can borrow money to purchase a property. Most real estate transactions require 20% down payment. So, to lower your investment basis, you’d need to minimize your down payment, closing costs and repairs. And down payment is a factor many investors have control over. Before you feel tempted to take out the biggest possible mortgage to buy a property, be mindful of the relative risks associated with a large mortgage payment. You don’t want to go into a foreclosure on a property due to some unforeseen situations where you cannot make the big mortgage payments.

To optimize your CoCRoI, it’s best you decide on number ranges that you feel comfortable working with. You want to maximize your rate of return, yet, how much to leverage depends on your level of risk tolerance. Don’t let big mortgage payments keep you up at night. Familiarize yourself with all the factors (and subfactors) that are part of the CoCRoI equation and determine how those factors work together relative to each other to influence the CoCRoI yield.

Cash on Cash Return Limitations

Calculating the CoCRoI requires you to do more research and get down to the nitty gritty of numbers, but the math is rather quick once you’ve got all the numbers. And because you have to get more numbers, in general, the tool is more efficient and effective at evaluating potential real estate deals (compared to the 50% or 1% rules). Click here to read my other article, using the 50% and 1% screening rules to filter potential deals and the rules’ limitations.

As in the 50% and 1% rules article, I’m ending this one sharing with you some limitations associated with the Cash on Cash Return metric.

First, the Cash and Cash Return metric is most effective looking at a property’s rate of return in the first year. After the first year, assumptions would have to be made about future return. As an example taking another look at the factors that influence the CoCRoI yield, the denominator is the property’s investment basis. This number will be constantly changing after year one, as you pay down on the loan. You would have added more equity through the additional principal portion of your loan payment to your investment basis (also known as equity accrual). The Cash on Cash Return formula does not automatically account for principal payments.

Second, the Cash on Cash Return metric doesn’t indicate your actual return. As you might recall, the numerator of the formula is pretax annual cash flow. Thus, your actual return on an investment really depends on your tax situation. For instance, on an investment basis of $100,000, if your pretax annual cash flow is $10,000, then Cash on Cash Return is 10%. If you are in the 25% tax bracket, your after-tax cash flow is $7500, resulting in a 7.5% actual return. However, if you are in the 35% tax bracket, your actual return is 6.5%.

Your tax situation can also affect your actual return through the amount you can deduct on depreciation. In the example above, if your depreciation amount is $3000, then only $7,000 of cash flow is subject to income tax. At 25% tax bracket, the amount you’re responsible for tax is $1,750 [7,000 x .25]. When you subtract $1,750 (an expense) from $10,000 (pre-tax cash flow), your after-tax cash flow is $8,250, resulting in 8.25% actual return. Thus, your tax situation definitely affects your actual returns. However, the Cash on Cash Return metric doesn’t factor in income tax.

Third, the CoCRoI metric doesn’t indicate anything about fluctuations in rent over time. Rent is likely to go up over the years due to the rental market (supply & demand) and inflation. When rent goes up, increase on gross income follows, which improves the CoCRoI yield.

Fourth, the Cash on Cash Return metric doesn’t take into account appreciation. This is an important factor to consider if you’re buying into speculation, hoping that your investment property will go up in value in future years. If you believe your property might double in value in 5 or 10 years, that might influence how you approach the Cash on Cash Return yield. For instance, when you purchase an investment property speculating large increase in appreciation, you might be okay with a lower CoCRoI than the next investor who doesn’t want to account for appreciation in his financial analyses.

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In my future real estate investing analyses, I will first start with the 50% and 1% screening rules to filter out potential deals. Then, I will use the CoCRoI metric, along with a few more others, which I will share in future posts. This is generally a good rule of thumb. You want to use as many available metrics to supplement your analyses before making a purchasing decision.

Readers, if you are a real estate investor, do you calculate CoCRoI? What do you think are some of the metric’s pros and cons?

If you’re a prospect real estate investor, will you be using this metric?

What other metrics might you be using to help you make purchase decisions?