Cash-on-Cash Return: The Ultimate Guide!

Investors use multiple metrics to evaluate investment opportunities, such as cap rate, internal rate of return (IRR) and cash-on-cash return, which help them to make sound decisions. Usually, investors look at hundreds of deals before investing in any single one, so these metrics help them sort before focusing their attention on a select few.

A cash-on-cash return is a rate of return often used in real estate transactions that calculates the cash income earned against the cash invested in a property. In simpler words, Cash-on-cash return (abbreviated as CoC return) is an annual measure of the investor’s earnings on a property compared to the amount the investor initially spent to purchase and make it operational. The amount of the total cash earned is calculated on the annual pre-tax cash flow.

 

A cash-on-cash return is used to measure commercial real estate investment performance. This rate provides investors with an analysis of the property plan and the potential cash distributions over the life of the investment. The CoC return analysis is for investment properties that involve long-term debt borrowing. Cash-on-cash return only measures the return on the actual cash invested, resulting in a more accurate analysis of the investment's performance.

 

Cash-on-cash return is the annual cash flow (pre-tax) divided by the total cash investment.

To calculate pre-tax cash flow for the year, add up gross rent intake for the year, along with any other income received from the property, such as rent for parking spaces or storage units. Now, subtract operating expenses (viz property manager, handyman, plumber, gardener, other regular upkeep) and annual mortgage payments.

Next, divide pre-tax cash flow by all the money initially invested into the property, which is the total cash invested. This amount involves a down payment, closing costs, and any repairs or renovations made to the property. The resulting percentage will tell the cash-on-cash return.

Cash-on-cash return in real estate stays constant as long as the income from the property and investment into it remains consistent. Let us assume that the income increases as the property rent rises, which will drive cash-on-cash return to grow high. Or, if additional money needs to be invested into an unexpected repair, the cash-on-cash return will go down.

 

The formula for cash-on-cash return is:

 

Cash-on-Cash Return = Annual Pre-Tax Cash Flow​/Total Cash Invested

 

where:

Annual Pre-Tax Cash Flow = (GSR + OI) – (V + OE + AMP)

GSR = Gross scheduled rent

OI = Other income

V = Vacancy

OE = Operating expenses

AMP = Annual mortgage payments​

 

The cash-on-cash return is usually expressed as a percentage. While this ratio can be used in different business settings, it is most commonly used in commercial real estate transactions.

 

An investor invests $2.5 million in an apartment building. Aside from that, he paid $100,000 in various closing costs and fees. Hence, the total cash invested is ($2.5 million + $100,000) $2.6 million.

After one year, the rental revenue from the property is $1.2 million. In addition, mortgage payments, including both principal and interest payments, total $650,000. The investor spends another $250,000 on operating expenses and property improvements.

 

To determine the cash-on-cash return, first, we need to calculate the annual cash flow from the investment. 

So, the annual cash flow from the first year:

Annual net cash flow = total gross revenue - total expenses

Annual net cash flow = $1.2 million - $900,000

Annual net cash flow = $300,000

 

Now, divide the annual net cash flow by the total cash invested to calculate the cash-on-cash return.

 

Cash-on-cash return = $300,000 / $2,600,000 = 11.5%

 

The total cash-on-cash return for the property is 11.5%. It means that the annual profit against that property for the first year will be 11.5% of the cash initially invested.

 

Let us consider one more example where a development firm decides to purchase a commercial space for $1 million. The company pays $300,000 in down payment and takes a mortgage of $700,000 from a bank. Besides the down payment, the firm paid $30,000 in various fees. The firm is planning to lease the commercial space to numerous businesses.

After one year, the annual rental revenue from the property is $130,000. In addition, mortgage payments, including the principal repayment and the interest payments, are $40,000.

Now, as per the cash-on-cash return calculator, we need to determine the annual cash flow from the investment. 

 

So, the annual cash flow in the first year:

Annual cash flow = Annual rent – Payments against Mortgages

Annual cash flow = $130,000 – $40,000 = $90,000

 

Next, we must find out the total cash invested. It is the amount that the firm spent on the investment, excluding the leverage. Accordingly, the Total Cash invested is calculated by:

 

Total cash invested = Down payment + Various Fees

Total cash invested = $300,000 + $30,000 = $330,000

 

Hence, we can determine the cash-on-cash return in the first year:

 

Cash-on-cash return = $90,000 / $330,000 = 0.27 or 27%

 

It means that the annual profit gained by the development firm for that property for the first year will be 27% of the cash invested initially.

 

Every investor wants to know what is a "good" cash-on-cash return, but there is no direct answer to this question. Good cash-on-cash return depends on several factors, including the preferences of the investors. For example, a risk-averse investor might invest more equity into deals, thus, lowering the leverage. We know that the more equity, the lower the leverage and cost of financing, and hence the lower the cash-on-cash return. 

 

For some investors, an 8-10% cash-on-cash return is good if the property meets their investment objectives. Others might only like the deals with a minimum of 20% cash-on-cash return. These investors are required to utilize more leverage and less investment to reach that threshold.

 

The local market also plays its role in cash-on-cash returns. In particular, hot markets, since higher acquisition costs might require substantially more equity. The lower total cash-on-cash return might be acceptable if the income from the property is comparably high. Many investors are willing to accept lower cash-on-cash returns in primary markets with a robust economic base, especially if they are risk-averse or have a long investment horizon.

 

One way to compare deals using cash-on-cash return, an investor needs to assume that the same amount of equity is invested in each deal. Let us say an investor has $3 million to invest in five separate agreements equally. Based on the debt, income and expenses associated with each of those deals, assuming the total amount invested remains constant, the investor can determine which of the five deals results in the highest cash-on-cash return.

 

Cash-on-cash return generally stays the same, assuming that income and expenses remain unchanged. But, in the real world of real estate investing, rental income and operating expenses may change annually or even monthly.

Some factors that can make a cash-on-cash return from a rental property higher or lower include variation in the:

 

Hope this article gives you insight about the concept of cash-on-cash return, and you can always lean on us for a better understanding of real estate.