How Cash-on-Cash Return Is Used for Investment Comparisons

Sep 20 17:07 2008 James Kobzeff Print This Article

Learn all about cash-on-cash return, including its meaning, benefits and shortcomings, why real estate investors use it, and its formula.

In this real estate investing article,Guest Posting we want to discuss cash-on-cash return by exploring its meaning, benefits and shortcomings, popularity amongst real estate investors, and then the cash-on-cash formula alongside several examples.

So let's get started.

The cash-on-cash return (or equity dividend rate) measures the ratio between a property's anticipated first year's cash flow before tax (CFBT) to the amount of initial cash investment made by the real estate investor to purchase the rental property.

Here's the idea: cash on cash is the percentage of cash flow to cash investment.

Its popularity in real estate investing is due mostly to the fact that cash-on-cash provides an easy way for investors to compare profitability between multiple investment opportunities quickly. For example, an investor could compare the first-year yield of a real estate investment based on its cash-on-cash (or CoC) to the yield offered by a bank on a CD. In this case, for instance, the investor might decide to invest his cash into an apartment complex that returns a CoC of 7.6% rather than into a CD paying 3%, and vice versa.

As a rule, however, cash-on-cash return is not considered a particularly powerful tool for measuring the profitability of rental income property because it doesn't take into account time value of money. In other words, because it doesn't compound or discount money over time, CoC is restricted to measuring an investment property's cash flow in the first year of ownership only.

Nonetheless, the cash-on-cash return is not without validity. It certainly will provide real estate investors a quick way to compare investment opportunities and similar income-producing properties.

How to Calculate

Cash on Cash Return = Annual Cash Flow / Cash Investment

What It Means

Before we consider an example, let's be sure we understand the components of the formula. This will be crucial for you to compute cash-on-cash correctly in your own rental property analysis.

1) Annual Cash Flow - This is the cash flow before tax (CFBT) in opposition to the cash flow after tax (CFAT). In other words, it's the cash flow for the first-year without an adjustment for Federal income tax. CFBT is calculated by computing annual rental income less annual operating expense less annual debt service or loan payment.

2) Cash Investment - This is the total amount of initial cash required to purchase the property and includes the down payment, loan points, escrow and title fees, appraisal, and inspection costs.

Example

Okay, let's compute a cash-on-cash return.

You're interested in purchasing a six-unit multifamily property according to the following scenario. Each of the six units collects $1,000 per month. You estimate the first year's operating expenses will be $28,800. Your mortgage requires $126,000 down, loan points of $2,940, and a monthly loan payment of $1,956. You estimate your closing costs, i.e., escrow, title, inspections, and appraisal fees, at $2,100.

First, compute the annual cash flow:

Gross Scheduled Income $72,000 ((6 units x $1,000) x 12)) less Operating Expenses of $28,800 equals $43,200 (Net Operating Income) less Mortgage Payment $23,472 ($1,956 x 12) = $19,728 Cash Flow

Next, compute your cash investment:

Down Payment of $126,000 plus Loan Points of $2,940 plus Closing Costs of $2,100 = $131,040 Cash Investment

Finally, compute CoC:

Cash on Cash Return = Annual Cash Flow / Cash Investment, or, $19,728 / $131,040 = 15.06%

Okay, now let's apply it.

You're trying to decide where to invest $126,000 cash. You can invest it in a 3% T-Bill at your local bank or, as you just discovered, you can purchase a six-unit rental income property and get a cash-on-cash return of 15.06%. What do you do next? You might want to do a full-blown real estate analysis on the property and look at some other key returns and measures. Though the property appears on the surface to be the best investment opportunity you can't make a decision without more information and a more complete real estate analysis.

But here's the caveat. Be sure to use credible property data for your analysis; confirm that everything the seller or agent gives to you is complete and accurate; compute all numbers and property data concisely and carefully.

With that said, here's to your real estate investing success.

Source: Free Guest Posting Articles from ArticlesFactory.com

About Article Author

James Kobzeff
James Kobzeff

James Kobzeff is the developer of ProAPOD Real Estate Investment Software . Want to consider cash-on-cash return? Discover how to create cash flow and profitability analysis presentations with automatic rate of return calculations in minutes! Go to => http://www.proapod.com

View More Articles