Alright real estate moguls.
If you’ve been investing in real estate for a while, you might have heard of this famous metric:
This is a super easy to calculate metric used to evaluate the performance of your real estate investment/portfolio on a CASH BASIS (I’ll talk more about this later.)
It’s just one of the many calculations you should be carrying out to analyze financial performance. You really have to use it in conjunction with other formulas to get a full picture of your investment performance.
In this article, I’ll dive into what the cash-on-cash return is, where to get the required inputs for the calculation, and how you can go about calculating it.
What is cash-on-cash return?
Basically, it’s a formula you use to calculate how much pre-tax cash flow you’re getting over how much cash you invested.
Investors use cash-on-cash return for analyzing the historical performance of real estate investments vs. prior periods, or vs. benchmark portfolios etc.
The formula is as follows:
Cash-on-cash return = Pre-tax Cash Flow/Cash Amount Invested * 100
So for example, if your annual income from a real estate investment is $24,000, and your investment is $480,000, then your cash-on-cash return for that year is 5.00%.
What makes it different from other measures of return?
The whole point of cash-on-cash return is to understand your investment’s performance on a CASH BASIS. This means, for $x of cash you put into the investment, how many $ are you getting out of it?
Therefore, because it’s all cash based, you don’t consider non-cash items such as depreciation or capital gain in your calculations. If you’ve ever heard the phrase “cash is king” – that’s what this formula is trying to capture.
Smart investors know that capital gains, depreciation etc. are accounting-related items that do not reflect the REALIZED performance of your investments. You could have a really profitable venture on paper, only to realize that you’ve got cash flow problems.
Another thing to note: you’re working out your investment returns NET OF YOUR MORTGAGE. This means that your “Cash Amount Invested” component does not take into account the money paid by the bank etc. Your “Pre-Tax Cash Flow” is calculated after deducting mortgage repayments.
The Components of the Equation
Let’s turn now to the components of the cash-on-cash return equation. While the formula is simple to work out, it’s in the inputs that the danger lies.
Pre-tax Cash Flow
Our first component in the equation is pre-tax cash flow.
This relates to the “cash profit” that your investment makes. It’s broken down as follows:
|Add: Gross Rental income||The total amount of actual rental that you earned in the period|
|Add: Other Income||Any income that was not due to the property’s earning power. Insurance payouts that exceeded the value of damaged items, selling a piece of furniture for a butt load at a garage sale – these things will be found here.|
|Less: Operating Expenses||These are the costs associated solely with the management and maintenance of the property: e.g. repairs, cleaning, maintenance, property management, taxes, insurance etc.|
|Less: Mortgage Repayments||This usually includes your mortgage principal repayments and the interest.|
Cash Amount Invested
|Add: Down Payment||This is the cash amount that you paid OUT OF YOUR POCKET towards the purchase price of the property|
|Add: Closing Costs||These are the costs that you paid for closing – professional fees, commissions etc. I wouldn’t include inspection fees, research costs here because I treat that as sunk costs. That means I used that money for “R&D” purposes to find a good deal.|
|Add: Initial Rennovation/Repair Costs||Any costs that went into fixing up your property before you started renting it out will be included here. Repair costs etc, during the tenants’ tenure would be considered Operating Expenses.|
Bam! That’s all there is to it!
It’s really up to you what you want to consider in each input/component. It’s your investment after all, you decide how performance should be measured. You determine under what terms something is included in Pre-tax Cash Flow or Cash Amount Invested.
However, the important thing is to BE CONSISTENT, whether it’s between analysis periods or between investments. You don’t want to be changing your criteria from year to year. This will only lead to misguided insights!
A Warning: the Shortcomings of cash-on-cash return
One of the great benefits of the cash-on-cash return is also it’s greatest flaw. Because cash-on-cash return is so simple, it is also very rudimentary and unsophisticated.
Particularly if you’re using cash-on-cash return to determine the value of an investment (i.e. you’re looking at future earnings), then cash-on-cash loses out to IRR and MIRR analyses.
Cash-on-cash return is an easy to use metric that gives us a good snapshot of the performance of our investments. In fact, I use it regularly. However, it should be used in conjunction with other more in-depth analyses.
Here, I’ve used cash-on-cash return to analyze historical performance. But you can most definitely use it for projected financial performance too. This would require you to make predictions about expected vacancy rates, operating expense etc. This is outside the scope of my article for now, but we can definitely go over it in the future.
In the meantime, you can check out Bigger Pocket’s article on using cash-on-cash return for evaluating potential investments.
Let me know if you use cash-on-cash return by commenting below! Do you use the same components? What other formulas do you use?