What Is Cash-on-Cash Yield?
Cash-on-cash yield is a basic calculation used to estimate the return from an asset that generates income. This financial metric is commonly used to calculate returns for real estate investments. Cash-on-cash yield also refers to the total amount of distributions paid annually by an income trust as a percentage of its current price. The cash-on-cash yield is a measurement technique that can be used to compare different unit trusts. Thisterm is also referred to as cash-on-cash return.
Key Takeaways
- Cash-on-cash yield is used to calculate an asset's return.
- It is extensively used in valuations of commercial real estate calculations.
- Cash-on-cash yield can be used to determine whether a property is overvalued or undervalued. But it is not a fully promised outlay.
- It cannot be completely relied on for accuracy because the metric may overstate yield if part of the distribution consists of a return of capital instead of a return on invested capital.
Formula and Calculation of Cash-on-Cash Yield
Cash-on-cash yield is useful as an initial estimate of the return from an investment and can be calculated as follows:
Cash-on-Cash Yield = Annual Net Cash Flow ÷ Invested Equity
For example, if an apartment priced at $200,000 generates a monthly rental income of $1,000, the cash-on-cash yield on an annualized basis would be 6% ($1,000 x 12 ÷ $200,000 = 0.06).
In the context of income trusts, assume a trust with a current market price of $20 pays out $2 in annual distributions, consisting of $1.50 in income and 50 cents in ROC. The cash-on-cash yield in this case is 10%; however, since part of the distribution consists of the return of ROC, the actual yield is 7.5%. The cash-on-cash yield measure overstates the return in this case.
Understanding Cash-on-Cash Yield
As noted above, a cash-on-cash yield is the return generated by an income-producing asset. It is commonly used to describe the return of commercial real estate assets—notably income or investment properties. As such, real estate investors and professionals use this metric to measure a property's investment performance. It is also used to determine annual distributions paid by income trusts as a percentage of their current price.
An asset's cash-on-cash yield can also be used to make projections or forecasts about an asset's future returns. Rather than calculating a guaranteed return, it is an estimate. As such, investors can use the formula above to calculate what they may earn as a return over the life of the investment.
Unlike similar metrics, an asset's cash-on-cash yield takes debt payments into account. But, the cash-on-cash yield has certain limitations. The metric may overstate yield if part of the distribution consists of a return of capital (ROC), rather than a return on invested capital (ROIC). This is often the case with income trusts. It doesn't account for taxes as a pre-tax measure of return.
Cash-on-Cash Yield and Real Estate Value Calculations
Cash-on-cash yield is often used in the real estate market when valuing commercial properties, particularly ones that involve long-term debt borrowing. This yield can also be used when determining if a property is undervalued. When debt is noted in a real estate transaction (as is usually the case), the actual cash return of the investment differs from the standard return on investment (ROI).
Cash-on-cash yield does not include any appreciation or depreciation in the investment. Calculations based on standard ROI will incorporate the total return of an investment; on the other hand, cash-on-cash yield simply measures the return on the actual cash invested.
A cash-on-cash yield is different from a monthly coupon distribution. Rather than being a fully promised outlay, it can only be used as an estimate to assess future potential.
Example of Cash-on-Cash Yield
Suppose a real estate company purchases a property for $500,000. It spends a further $100,000 on repairs to the building. To finance its purchase, the company makes a down payment of $100,000 and takes out a loan of $400,000 with yearly mortgage payments of $20,000. The company earns $50,000 in rental income during the first year.
The calculation for its cash-on-cash yield begins with cash flow. The cash flow for the company is $50,000 - $20,000 = $30,000. The total amount invested in the building is $220,000 = $100,000 (down payment) + $100,000 (repairs to the building) + $20,000 (mortgage payment). The building's cash-on-cash yield is 13.6% ($30,000 ÷ $220,000).
What Is a Good Cash-on-Cash Yield?
There isn't an easy answer to this question. What makes a good cash-on-cash yield depends on the investor and several factors, including the property's location, market conditions, and an investor's risk tolerance. Some people generally consider a range of 7% to 10% to be an acceptable
What's the Difference Between Cash-on-Cash Yield and Internal Rate of Return?
A cash-on-cash yield can be used to determine an income-producing asset's return. It is normally used to calculate and project returns for real estate investments, including properties and income trusts. An internal rate of return (IRR) calculates an investment's expected return. While the cash-on-cash yield is used to determine an investment's annual return, the IRR is used to show an investor the return they can earn during the lifetime of the investment.
What Are the Limitations of Cash-on-Cash Yield?
Real estate investors can use an asset's cash-on-cash yield to help them determine its investment performance. But, the yield can be overstated because it may not account for certain factors, including taxes a pre-tax measure of return.
The Bottom Line
Real estate can be tricky to navigate. But, there are certain metrics investors can use to help them make important decisions about potential investments. The cash-on-cash yield can be used to calculate returns for their real estate investments—notably commercial property and income trusts. This is done by figuring out the net cash flow per year and dividing that by the total equity invested.
