«

»

Oct 08

Understanding Cash-on-Cash Return

Understanding cash on cash returns

Understanding cash on cash returns

Real Estate Investing for Beginners: Understanding Cash-on-Cash Return

One of the most popular measurements used for real estate investing for beginners is called the cash-on-cash return. This metric is simply a percentage used to measure the return on cash actually invested into a rental property. It’s useful for predicting the financial performance of an income property for the first year of ownership.

A lot of people investing in real estate pay close attention to this rate of return because it gives them a simple way to compare the profitability of a number of investments at once. While the cash-on-cash return is very useful to real estate investors, it’s not quite as handy as once thought because the formula fails to consider the time value of invested capital. Consequently, the formula is limited to only measuring the first year of cash flow for an income property, and ignores any future cash flow.

How Does Cash on Cash Return Work?

You calculate the cash-on-cash return by dividing your before-tax cash flow by your acquisition cash investment into the property, and then express the result in terms of a percentage. Here are the definitions for the terminology:

First-year of cash flow — This is how much money a property generates during its first operating year.

Acquisition cash investment — This is how much money that’s been invested to acquire any property and prepare it for tenants. It includes the down payment, any loan points paid, escrow fees, title fees, property inspection, appraisal, plus maintenance and repairs.

Let’s Look at an Example

Let’s assume that you want to purchase a six unit apartment building that earns $1,000 per month in rent per unit. Your estimated operating expenses for the first year are $30,000. You plan to take out a new loan using a $125,000 down payment and pay $3,000 in loan points to end up with monthly loan payments of $2,000. And finally, your estimated closing costs come in at $2,500.

In the above example, you’ll have to make a number of computations to determine what your cash flow and acquisition cash investment will be for the first year before you can calculate your cash-on-cash return. Here are the calculations you have to perform:

  1. Gross Rental Income: (6 units x $1,000) x 12 months = $72,000
  2. Net Operating Income: $72,000 – $30,000 = $42,000
  3. Mortgage Payments: $2,000 x 12 = $24,000
  4. Cash Flow for the First Year: $42,000 – $24,000 = $18,000
  5. Acquisition Cash Investment: $125,000 + $3,000 + $2,500 = $130,500

 Cash-On-Cash Return Formula:

First-year of Cash Flow /Acquisition Cash Investment = Cash-on-Cash Return

$18,000/$130,500 = 13.79%

 

With the specific cash-on-cash return of this real estate investment of 13.79% in hand, you’re able to compare it with comparable properties, or alternate ways of investing your capital, such as in T-bills, or you can even decide if the resulting cash-on-cash payback meets your minimum return on investment requirements altogether for passive income.

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <s> <strike> <strong>