What is Cash On Cash Return and why is it important?
Net Cash Flow ÷ Invested Cash
Cash on cash return or COC return, is the amount of cash flow (rental income less mortgage, taxes, insurance, maintenance) your rental property or real estate investment generates as a percentage of the amount of capital you invested in the property, another way, a cash yield. If your rental generates $10,000 per year in free cash flow and you have invested $50,000 to buy and renovate the property (i.e. down payment plus closing costs and rehab), your cash on cash return is 20%. This is otherwise known as return on invested capital (ROIC)
Detailed Example
Cash on cash return calculates the cash return on for a property, let's take a look at a detailed example. A real estate investor buying a commercial real estate property for a purchase price of $1,000,000 with a $200,000 down (total cash invested). At the end of every month you get $4,000 in cash flow net of operating expenses. At the end of the year you would have accumulated $4,000 × 12 = $48,000 in net cash flow. So the net operating income (NOI) on cash would be calculated as:
$40,000/$200,000 = 0.20 ~> 20%
However, since real estate investor used debt to acquire this property, a payment that must go out to the lender each month to cover the mortgage payments. There is another common metric that captures this relationship between cash flow and debt service, called the debt service coverage ratio (DSCR). Due to this the $48,000 in cash the investor received is not what he gets to keep. For the $800,000 ($1,000,000 purchase price minus $200,000 cash downpayment) they got in debt to finance this purchase, they must pay $1,500 in monthly mortgage payments.
Now to calculate the cash on cash return, we must, take the monthly $4,000 in net cash flow, subtract $1,500 in mortgage payments which includes (interest payment and principal payment), netting $2,500 in monthly income. We must take this amount for the whole year and divide it by total cash invested to get out cash on cash return
(($4,000 - $1,500) * 12) / $200,000 = 0.15 ~> 15%
15% percent is the cash on cash return in this transaction. This examples simplifies several things, specifically the tax situation of the transaction which would most likely lower the cash on cash return further. This measures the return on the cash the investor had to put into the transaction net of all possible expenses. Another good measure
What is a good cash on cash return rate?
It's hard to quantify what is a good cash on cash return rate. Cash on cash return rates wildly differ from location to location and might not fully capture all financial incentives to own a property. For example, some areas with lower cash on cash return might have stellar property appreciation rates, where and exit after a few years will more than make up for a lack luster cash on cash return rate. We have seen cash on cash return rate in the 7% to 11% range to be attractive to buy and hold investors that were not planning on flipping property for many years, with lower range being applicable to areas where property appreciation and demographic trends might make up for lower cash on cash return. Additionally this rate might be wildly different between single family, multi family and commercial properties so make sure to always compare apples to apples.
One more considerations is usage of debt to structure the deal. In all cash deals, the denominator of the equation will be much higher producing a worse cash on cash return, thus using debt in the deal will artificially inflate the cash on cash metric's attractiveness. This makes this metric really good for comparing between several investment options where you know you will use a certain, fixed percentage of debt, location is similar and the property type is the same, but makes it a poor metric to look at individual properties where you are not comparing it to anything similar in terms of financing structure.
Shortfalls of the cash on cash metric
This metric is based on before tax cash flows investor receive from the property thus the metric ignore taxes applicable to the investor. This may distort the attractiveness of the investment if taxes are higher in certain jurisdictions and are completely ignored by this metric.
Interestingly, the real estate investor can deduct or even defer capita cost allowance (CCA) to lower their marginal tax rate to increase the attractiveness of the property on cash on cash basis
The formula is completely numbers driven and ignores any factor that is associated with the actual property, such as its location, condition, rental market climate, local government climate, public investment direction and many other factors that are important to consider when making an investment decision.
Additional inputs are needed to accurately describe the financial position and cash returns, such as adjusted taxable income of the investor, depreciation, expenses associated with maintenance and rental of the property to gain an accurate picture on the attractiveness of the investment.
The formula completely ignores the effects of compounding interest payments. While we take out the debt payments from the cashflow we ignore any effects of compounding and this is a critical shortcoming since a property with lower nominal rate of interest compounding may be a better investment than an investment with a higher cash on cash return.
As stated above, this formula completely ignores more qualitative factors that take time to discover about the property itself such as depreciation (tax) and actual depreciation rate, the outlays you have to maintain the property in rentable condition. Additionally, no property appreciation (resale value of the property) increases or decreases are taken in to the account. While the property might be cash flowing and have a good return, an exit from the position might be impossible if the property attractiveness or market declines making it an overall a bad investment.
It is possible to have an incalculable Cash On Cash Return if you use the BRRR method highly effectively and pull all or more than the cash you originally invested out of the property by mortgage refinancing.
In conclusion, cash on cash return is a great metric to take into account when considering an investment into a rental property, but it's can't be the only criteria for evaluating an investment. Other metrics and qualitative factors regarding the property must be part of the analysis of the attractiveness of the property under evaluation.
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