Determining a property’s cash-on-cash return is widely recognized as one of the smartest things an investor can do before fully committing to a deal. At the very least, a basic cash-on-cash return calculation may help identify a deal’s true potential. In addition to identifying viable candidates, this important metric can also help investors avoid making huge mistakes, which is perhaps even more important. There isn’t a single investor who wouldn’t benefit from a better understanding of how to calculate cash-on-cash return rates of prospective deals.
The cash-on-cash return formula is relatively simple: divide the annual income from the investment (before taxes are taken out) by the amount invested in the real estate asset. The resulting value will be expressed as a decimal. To convert the resulting decimal into a percentage, which will represent the cash-on-cash return, simply multiply the resulting decimal by 100.
It is worth noting, however, that several factors go into calculating the variables involved in the cash-on-cash return formula. For the formula to work correctly, investors need to know how to calculate both the annual income from the investment (pre-tax cash flow) and the actual amount invested. Once these two variables are calculated, they may be entered into the cash-on-cash return formula.
Here’s how to calculate the two variables investors will need to plug into the cash-on-cash return formula.
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To calculate the pre-tax cash flow of a real estate asset (the annual income before taxes are taken out), investors will need to be able to account for every expense they will incur from owning the property each month. Common expenses include, but are not limited to:
Mortgage payments
Property taxes and insurance
Maintenance costs
Utilities
Property management fees
Operating expenses
Vacancy rate
HOA fees (if applicable)
Investors will need to create an itemized list of every expense they expect to incur each month. Once all of the expenses are accounted for, the next step is to subtract them from the amount of money being brought in by the asset.
Let’s say, for example, a rental property brings in $2,000 a month in rent, but it costs $1,500 to own and operate. At the end of each month, the landlord will walk away with $500 (their pre-tax cash flow). In order to apply the new variable to the cash-on-cash return formula, however, it must be converted into an annual rate. To do so, simply multiply the monthly cash flow by 12. In this case, the annual cash flow would be $6,000 ($500×12). Remember this “annual pre-tax cash flow” number, as it will be used in the cash-on-cash formula later.
Calculating the actual cash invested is a bit more straightforward. In order to calculate how much money was invested in a real estate asset, investors simply need to add up any funds they used to acquire the home. Common costs include, but are not limited to:
Down payment
Closing costs
Improvements or repairs made to the property
The resulting number will be plugged into the cash-on-cash return formula.
The cash-on-cash return formula looks like this:
Cash-On-Cash Return = (Annual Pre-Tax Cash Flow / Total Cash Invested) x 100%
Let’s say, for example, an investor’s initial cash investment is $70,000, and their annual cash flow is $6,000. Using the cash-on-cash formula ($6,000/$70,000), the investor will wind up with an answer in the form of a decimal: 0.085 (rounded to the nearest thousandth), which equates to 8.5%. The resulting percentage represents the real estate investment’s cash-on-cash return.
Using the cash-on-cash return calculator correctly is a valuable skill for every investor to learn. At the very least, understanding how to calculate cash-on-cash return formulas will help investors determine the potential profitability of a real estate asset. Perhaps even more importantly, an asset’s cash-on-cash return (expressed as a percentage) may help investors compare two investments that may or may not be similar. That means an investor can compare the cash-on-cash return of a rental property with a rehab, and determine which investment has more potential.
It is worth noting, however, that while an asset’s cash-on-cash return is an important tool for investors to be able to translate, it’s not without a few caveats of its own. There are several factors investors need to consider in order to fully understand the concept of a cash-on-cash return, not the least of which are outlined below.
Cash-on-cash return real estate formulas do not take a person’s individual tax situation into consideration, which could potentially deduct even more from their cash flow.
Even a perfect cash-on-cash return calculation can’t account for appreciation or depreciation. As a result, the cash-on-cash rate of return isn’t completely accurate. Likewise, these calculations are better suited for short-term usage.
Cash-on-cash real estate calculations don’t account for any level of risk.
Cash-on-cash ROI calculations ignore the prospect of compounding interest.
Cash-on-cash return is not the same as ROI (return on investment). While the two sound inherently similar, they are not able to be used interchangeably. While cash-on-cash returns look at profits relative to the cash spent on a particular investment (before tax), ROI tends to account for returns on the total investment, which include loans that were taken out to finance the purchase. To be perfectly clear, calculating an asset’s return on investment will take the total return on investment into consideration. The cash-on-cash route, on the other hand, only measures returns on the cash invested out of an investor’s pocket.
Cash-on-cash return calculations do include principal mortgage payments. Basic cash-on-cash formulas account for a property’s cash flow, which is influenced by the monthly mortgage obligations paid by the owner. Therefore, while principal payments are not represented by a variable in a cash-on-cash formula, they factor into the property’s cash flow, which is an important element in determining a home’s cash-on-cash percentage.
Cash-on-cash return is one of several metrics used by real estate investors to evaluate the current or future profitability of an investment property. Expressed as a percentage, the cash-on-cash return of a real estate asset may compare two dissimilar properties, too. Cap rate (capitalization rate), on the other hand, is used to compare similar real estate assets. For example, a cap rate would be perfect for someone to compare returns from two rental properties.
In an industry where absolutely nothing is more important than risk mitigation, traditional cash-on-cash return formulas have helped investors compare and evaluate potential deals with an acceptable degree of accuracy. In fact, looking at the cash-on-cash return of a prospective real estate asset has just as much to do with potential as it does with limiting one’s exposure to risk. As a result, there isn’t a single investor who couldn’t stand to benefit from a better understanding of how to calculate cash-on-cash return. Fully grasping the concept of an asset’s potential performance is integral in realizing success in today’s housing market.
Key Takeaways
What is cash-on-cash return, if not for an invaluable tool used by investors to determine a deals profitability?
Understanding how to calculate cash-on-cash return will require investors to know every detail about a deal’s financing.
Cash-on-cash return real estate calculations are great for comparing dissimilar deals.