If you’re a real estate investor or rental property owner, cash flow is an important metric to assess the value of your investments. The cash-on-cash return metric is one of the most commonly used cash flow measurements that can give you valuable insights into how well your rental property performs based on the actual cash received.
This blog post will look at cash-on-cash return and explain why it’s an essential metric for real estate investors and rental property owners. We’ll also discuss how to calculate cash-on-cash return and provide tips for interpreting the results so you can make better investment decisions.
Understanding cash-on-cash return is essential if you’re getting started as an investor or have been in the game for years. Read on to find out more!
What Is Cash-on-Cash Return?
Cash-on-cash return (or CoC return) measures annual pre-tax cash flow from an investment property. It is one of the most important metrics used in the real estate industry. It helps investors determine their actual or estimated pre-tax cash flow based on the annual income they earn from single-family, vacation rentals, and multifamily rental properties divided by the amount of cash invested in the property.
It’s a way to measure how much “cash back” or cash yield you are getting each year as an investor, considering all of your expenses, such as mortgage payments, repairs, and taxes. Cash-on-cash returns can be used to compare different investment opportunities within the same market or evaluate different markets against each other. This makes it a handy tool when deciding which real estate market suits you.
How to Calculate Cash-on-Cash Return
The cash-on-cash return formula is relatively simple:
- Rental Income – Expenses = Pre-Tax Cash Flow / Total Investment in Property
To calculate pre-tax cash flow for a given investment property, you’ll need to subtract annual expenses such as debt service, taxes, insurance premiums, and other operating costs from your pre-tax rental income. The pre-tax net cash flow can then be divided by the total cash invested in the property (including purchase price plus closing costs) to get the cash-on-cash return figure.
Cash-on-Cash Return Examples
Let’s look at two examples of calculating rental property cash-on-cash return. The first example assumes an investor pays all cash. In contrast, in the second example, an investor uses leverage by making a down payment and obtaining a mortgage for the balance of the purchase price.
Say you purchased an investment property for $150,000 in cash. If you received gross annual rent of $18,000 and spent $8,000 per year on operating expenses such as maintenance and repairs, property taxes, and landlord insurance, your pre-tax cash flow would be $10,000. After dividing that pre-tax cash flow by the total investment of $150,000, your cash-on-cash return for the property would be 6.7%:
- $18,000 Rental Income – $8,000 Annual Expenses = $10,000 Pre-Tax Cash Flow / $150,000 Total Investment in Property = 0.0666 or 6.7%
Cash-on-cash return with leverage
Leverage in real estate investing uses borrowed money, such as a loan or line of credit from a lender, to purchase an asset. This allows investors to control much more expensive properties than they could otherwise afford.
To illustrate, assume a property purchased at $150,000 with a 10% down payment ($15,000) produces a pre-tax cash flow of $2,000 after deducting all operating expenses, interest expenses, and mortgage payments. This results in an annual cash-on-cash return of 13.3%:
- $2,000 Pre-Tax Cash Flow / $15,000 Total Investment in Property = 0.1333 or 13.3%
This means that for each dollar invested in the property ($15,000), the investor will receive an average of thirteen cents in return during the first year of ownership. Compared to other investments, such as stocks or bonds, this is a very attractive return rate for real estate investors.
Leveraging increases potential returns on investments because it magnifies gains. However, leveraging can be risky if misused and can increase the investor’s exposure to financial losses. Therefore, it is essential for any investor considering leveraging in real estate investing in weighing the risks versus the rewards carefully before making any decisions.
What Is a Good Cash-on-Cash Return?
Cash flow analysis is an important tool for real estate investors and rental property owners to assess investment performance. When interpreting results from a cash flow analysis, it’s important to remember that higher numbers are generally better – meaning that higher pre-tax cash flows and higher returns indicate higher levels of profitability for an investment property.
It can also help to compare your results to the average pre-tax cash flow for similar properties in the same market. This will give you an idea of how your investment is performing relative to other properties in the area, which can provide valuable insights into future potential returns.
Factors Affecting Cash Return
Several factors can affect cash-on-cash return from a rental property. The first is the amount of rent charged to tenants, which will directly influence your pre-tax cash flow and subsequent cash on cash return. For example, a higher rent will generate more pre-tax income, resulting in a higher return on investment percentage. Conversely, lower rents may lead to diminishing returns.
The second factor is operating expenses such as maintenance, repairs, insurance premiums, and property taxes. These costs can increase or decrease depending on how well the property is maintained, what type of insurance policy is secured, and local taxation laws. As with rents, higher expenses reduce net pre-tax income and thus reduce the overall rate of return.
The third factor is leverage, which can amplify the effects of both rent and expenses. Leveraging allows investors to purchase a property with a higher market value with less of their own money but also exposes them to greater risks. By leveraging at higher rates, investors can increase their returns if rents remain steady or increase; however, higher leverage means a bigger financial burden if rents are lowered or expenses increase suddenly.
Other Metrics To Consider
While cash-on-cash return can be a valuable metric for evaluating potential investments, it does have some drawbacks. For example, it does not consider appreciation and so may neglect to consider an opportunity’s long-term potential if that property has the potential to appreciate significantly over time. Additionally, cash-on-cash return only reflects pre-tax income and may underestimate a property’s true returns after taxes are factored in.
That’s why savvy real estate investors use a variety of metrics to measure rental property returns. In addition to cash-on-cash return, four other popular metrics are cap rate, gross rent multiplier, IRR, and cash flow. Each of these metrics provides a different perspective on returns. They can give a more holistic view of a rental property’s performance when used together.
Cap rate – or capitalization rate – is a measure of the annual return on investment, expressed as a percentage. It is calculated by dividing the net operating income (NOI) by the purchase price. For example, if a property has a net operating income of $10,000 and a purchase price of $150,000, the cap rate would be 6.7%.
Net operating income (NOI) is a rental property’s total income minus its operating expenses. It is the amount of money left after all expenses associated with owning and managing the property have been paid – including insurance premiums, property taxes, repairs, maintenance, and other costs.
However, no mortgage payments, depreciation, or capital expenditures are included in NOI calculations. As a result, cash flow can be lower than NOI, depending on how much financing has been taken out for a particular investment property.
Gross rent multiplier
The gross rent multiplier (GRM) measures the relationship between the purchase price and the yearly rent. It is calculated by dividing the purchase price by the yearly rent. For example, if a property has a purchase price of $150,000 and an annual rent of $18,000, the gross rent multiplier would be 8.3.
By comparing properties with similar rents and purchase prices, an investor can better understand which ones may be more profitable in terms of rental income. The higher a property’s GRM, the less likely it is to generate positive cash flow. Conversely, a lower GRM indicates that the rent-to-price ratio is more favorable and may provide greater profit potential over time.
Internal rate of return
Internal rate of return (IRR) measures the profitability of rental property investment over time. It is the rate at which a real estate investor can expect to earn back the money they put into an investment, including interest earned and cash flows associated with it.
IRR is calculated as a percentage by considering all future cash flows from the rental property investment plus any capital gains or losses. Generally, when reviewing potential rental property investments, real estate investors will look for an IRR that meets their target rate of return. Suppose the calculated IRR does not meet this target rate of return. In that case, it may lead the investor to reconsider the investment or seek alternative options.
Cash flow is the difference between the income generated by a property and the expenses associated with it. Cash flow can be positive or negative, depending on whether the income from the property exceeds the expenses. Positive cash flow indicates that an investment is profitable, while negative cash flow indicates that it is not.
Some investors may intentionally invest in properties with short-term negative cash flow because they believe these investments present more potential for upside in the long run. By utilizing strategies such as refinancing, increasing rent prices over time, or improving the property to attract higher-paying tenants, investors may be able to increase their returns on these investments and make them more profitable.
Cash-on-cash return is a crucial metric for real estate investors and rental property owners because it provides insight into pre-tax cash flow from a given investment property. By understanding how to calculate pre-tax cash flow and interpreting the results, you can make smarter decisions when deciding where to invest your money in the real estate market.
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