There are several metrics investors use when evaluating various investment opportunities. Metrics like cap rate, internal rate of return (IRR) and cash-on-cash return allow investors to make a quick, apples to apples comparison of the opportunities before them. Some investors have certain thresholds (i.e., the metric must hit a certain number) for them to pursue the deal in earnest. Many investors look at hundreds of deals before investing in any single one, so these metrics help them wade through the masses before focusing their attention on a select few.
In this article, we look at "cash on cash"returns as a metric some investors use to evaluate investment opportunities.
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How to Calculate a Cash on CashReturn
Cash on cash return is a rate of return ratiothat calculates the total cash earned on the total cash (equity) invested in adeal. It is defined as cash flow before tax (i.e., cash flow after financing)in a given period, divided by the equity invested as of the end of that period.Cash on cash return is a levered (i.e.,after-debt) metric, whereas the "free and clear" return is its unleveredequivalent. Cash on cash return is a metric used by real estate investors toassess potential investment opportunities. It issometimes referred to as the "cash yield" on an investment.
The cash on cash return formula is simple:
AnnualNet Cash Flow / Invested Equity = Cashon Cash Return
The cash on cash return is generally expressedas a percentage. While this ratio can be used in several business settings, itis most commonly used in commercial real estate transactions.
By way of example: Let's say a sponsor decidesto purchase an apartment building for $10 million. The sponsor pools $2.5million of equity to invest in the deal and then finances the remaining $7.5million. Aside from the down payment, the sponsor paid $200,000 in variousclosing costs and fees. Therefore, totalequity invested is $2.7 million.
After one year, the annual rental revenue fromthe property is $1.2 million. In addition, mortgage payments, including bothprincipal and interest payments, total $550,000. The sponsor spends another$200,000 on operating expenses and property improvements.
Todetermine the cash on cash return, you must first calculate the annual cashflow from the investment. The annual cash flow fromthe first year is:
- Annualnet cash flow = total gross revenue - total expenses
- Annualnet cash flow = $1.2 million - $750,000
- Annualnet cash flow = $450,000
Now, we dividethe annual net cash flow by equity invested to determine the cash on cashreturn.
- $450,000/ $2,700,000 = 16.7%
The property's total cash on cash return is16.7%. TIs means that the property's annual profit for that year will be 16.7%of the cash initially invested.
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Benefits of a Cash on Cash Return
There are many reasons why investors like tocalculate a property's cash on cash returns.
The first, most practical use of cash on cashreturn is for property selection.Cash on cash return allows investors to conducta quick, side-by-side analysis of multiple deals based on the informationavailable to them (i.e., the rent roll, operating expenses and other financialsprovided by the seller).
Another reason investors like to usecash-on-cash return compared to other metrics is that it factors in the cost offinancing. This helps investorsdetermine what terms they'd need in order to achieve a certain cash on cashreturn. When an investor has more equity in the deal (as a percentage ofthe loan-to-value), the cash on cash return will generally be lower than if aninvestor has less equity in the deal. The calculationskews downward as more equity is invested, assuming revenues and costsremain constant otherwise. Of course, the cost of financing can also impact thecash on cash return and therefore, this calculation can motivate an investor toshop around for better loan rates and terms.
Finally, cash on cash returns provide usefulinsights as to a property's expense profile. Properties with higher expenseswill result in lower cash on cash returns, assuming all else remains equal. Aprospective buyer might look at thecurrent expenses to determine if there are cost savings that can be implementedto increase cash on cash returns.
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How Cash on Cash Returns Compareto Other Metrics
The cash on cash return is one of many metricsthat investors can use to evaluate investment opportunities. It differs fromother metrics as follows:
Cash on Cash vs. ROI: A property's return oninvestment is used to measure the overall rate of return on a property,including debt and cash, while cash on cash measures the return of the actualcash (equity) originally invested.
Cash on Cash vs Internal Rate of Return (IRR):The IRR is defined as the total interest earned on money invested. The primary difference between cash on cash returnsand IRR is that IRR is based on totalincome earned throughout the ownership cycle (vs. in annual segments, as isthe case with cash on cash returns). IRR calculations are much more complicatedand are based upon the time value of money financial principle.
Cash on Cash vs. Cap Rate: The cap ratecalculation assumes there is no debt on the property. If a property waspurchased with all cash (i.e., there is no debt service obligation), then thecash on cash return would be the same as the cap rate. However, because most investors usesome degree of leverage, these are generally different calculations.
What is a Good Cash on Cash Rateof Return?
Many investors want to know what is a "good"cash on cash return. There is no easy answer. A "good" cash on cash returndepends on several factors, including an investor's preferences. For example, arisk-adverse investor might opt toinvest more equity into deals, thereby lowering how much leverage they need.The more equity, the lower the leverage and cost of financing, the lower thecash on cash return. For some investors, an 8-10% cash on cash return is sufficient if the property otherwisemeets their investment objectives. Others might only look at deals with aminimum 20% cash on cash return. These investors might need to utilize moreleverage and less equity to reach that threshold.
The local market also influences cash on cashreturns. In particularly hot markets, higher acquisition costs might requiresubstantially more equity (in total dollars, not as a percentage ofloan-to-value). Unless income is comparably high, the total cash on cash returnmight be lower. Many investors arewilling to accept a lower cash on cash return in primary markets with strongunderlying economics, particularly if they are risk-adverse and/or have along investment horizon.
One wayfor an investor to compare deals using cash on cash returns is to assume thesame amount of equity is invested in each deal. Let'ssay an investor has $2 million to invest. They can use that $2 million toinvest in three separate deals.Based on the debt, income and expenses associated with each of those deals,assuming equity invested remains constant, the investor can determine which ofthe three deals results in the highest or "best" cash on cash return.
Related:Terms andDefinitions: Debt Terms
The Bottom Line
Ultimately, cash on cash return is a metricthat can be used to steer investors as they determine which investment will bemore or less profitable when compared to others - assuming the same equitycould be invested in a variety of ways (including but not limited to realestate investments). Cash on cashreturns are a useful metric but are always best used in conjunction with otherreal estate investing metrics like those outlined above.
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