Determining the return on investment for a prospective property can be tricky, and there are numerous tools and formulas out there that many claim are the “single” perfect trick. Cash on cash returns are often heralded as such. They’re a great way to estimate the return on investment for cash-based investments, certainly. But while they do have their uses, they also have limitations.
Today, let’s break down cash on cash returns and explain what they are and what a good one is when you see one.
What Is Cash on Cash Return?
In a nutshell, cash on cash return is cash flow for an investment in a given timeframe divided by the equity invested at the end of the same timeframe. Cash on cash return is also pre-tax, and it’s most often used by:
- real estate investors who want to figure out the suitability of potential real estate investments that are primarily or largely bought with cash, or
- investors that want to see how leverage affects their expected cash returns for an investment
Put another way, cash on cash return is a way to figure out how much cash income you earn based on your cash invested directly into a property. It’s also mostly used for annual estimates rather than monthly or quarterly.
What is the Cash on Cash Return Formula?
The cash on cash return formula is straightforward, like with many other real estate investment formulas:
- cash on cash return = the net operating income (NOI) / total cash investment
Your NOI is your annual rental income for a property minus any operating expenses, including maintenance and repair costs, licenses and other fees, costs for employees, and so on. It’s basically the income you have left after paying for all the expenses needed to maintain the property at a certain livable standard.
Meanwhile, total cash investment is any cash you need to pay in order to make the property operational in the first place. Such cash includes the money you use to pay for it upfront, closing and title costs, rehabilitation or repair costs, any additional loan fees, and anything else.
How to Calculate Cash on Cash Return Example
In this example of how to calculate cash on cash return let's assume you purchase a rental property that costs $200,000 and decide to pay with all-cash. That means $200,000 is your starting total cash investment. (In most cases, you’ll also need to pay a little extra for various rehab or closing costs, but we’ll keep the number simple for easy math.)
Say that you charge $2,000 of rent per month for the rental property you just purchased. This makes your annual rental income 12 x $2000, or $24,000. Then say that your operating expenses are about one-third of the cost, which takes you down to $16,000.
Now plug the numbers into the formula. You end up with $16,000 / $200,000 = 0.08 or 8%. In other words, your cash on cash return that you might generate from the property is 8%—provided that you actually paid for the entire thing in cash.
What Can a Cash on Cash Return Tell You?
A cash on cash return can provide a lot of valuable data for making real estate investment decisions. Since it’s essentially the cash yield for a possible property investment, it can give investors or business owners tools so they can come up with a good business plan for the property and figure out cash distribution schedules over the investment’s total lifespan.
In other words, it tells you how to spend your money most effectively over the course of an investment and how much you’ll earn every year or “leg”.
Because of these advantages, cash on cash returns are often used for any investment properties that include long-term debt borrowing. Many commercial properties require some debt to be incurred just because of the numbers involved, so the actual cash return for an investment could be dramatically different from the regular calculated return on investment. In these situations, cash on cash returns are pretty helpful.
That’s because the regular return on investment calculations look at the total long-term return on investment, while cash on cash returns only look at the return of the actual money invested into a property.
Additionally, you can use cash on cash return analysis to figure out how much money you should spend in a given investment period. This, in turn, will let you be flexible with your finances as you manage one or more properties that all draw from a single shared funding pool.
Not to mention that cash on cash returns are much easier to understand and calculate, especially compared to other types of return investment formulas. It’s a simple equation: how much cash will you have returned after 12 months given how much cash you invested?
A Tool for Leverage
Another way cash on cash returns can be helpful is that they’re good tools to examine the effect of leverage in a potential or given investment deal. Remember, cash on cash returns only ever deal with actual net cash flow and compare that amount to how much real cash you invest. A cash on cash return will be lower if you use more leverage (i.e., borrow more), so you can use these returns to look at multiple different investment strategies.
For instance, wondering if you should go into a deal with a lot of leverage or pay with as much cash as possible? Both routes may be useful, but a cash on cash return can cut through the math and show you simple, valuable numbers for analysis.
What is a Good Cash on Cash Return?
This is generally up to interpretation. However, higher numbers are obviously better since they represent you getting more cash return for the money you spent for an investment property over the course of a year (or any other timeframe, really). Generally, cash on cash return percentages of 10% or higher are great, although investors who are a little more ambitious might not accept properties that don’t provide cash on cash returns of even higher percentages.
Like with many things in real estate, what makes for a good cash on cash return largely depends on property values, location, rental strategies, and other aspects.
Cash on Cash Return Limitations
While cash on cash returns are excellent analytical tools to help you figure out the worth of a property, they do have a few limitations. Cash on cash returns don’t work when calculating for tax benefits for things like real estate appreciation – a huge factor in and of itself for long-term real estate investors!
Like with many other analytical tools, these are best used in conjunction with other financial estimation methods.
Cash on Cash Returns vs. ROI
ROI, or return on investment, is more a ratio of profitability than a measure of your actual cash returns each 12-month (or whatever) period. It’s a little broader of an analysis tool, looking at how much profit you can make when considering the entire cost of an investment, not just your cash investment.
Consider a commercial investment property that you examine using both analysis tools: cash on cash return will show your actual cash returns for that mortgage while the ROI looks at your long-term and overall profits when considering any additional leverage or debt you took on as well.
ROI is useful for figuring out how well your investment is doing in a broader sense. Both tools are helpful but should not really be compared or seen as competitors. Wise investors will likely use both for a holistic look at their potential returns or when deciding on a new investment.
In the end, cash on cash returns are easy-to-use tools to figure out how much of a cash return on investment you can expect in the short term. They are applicable both for cash-only investments and for determining how much leverage may affect a new investment. They’re also a great analysis tool since they’re easy to calculate and even easier to understand – hopefully even more so now that you’ve read this guide!
Use cash on cash returns alongside other real estate value analytical tools for best results. Good luck!