Cash on Cash Return Explained
If you've spent more than 4.7 seconds reading about real estate investing, you've heard the term "cash on cash return" tossed around like chicken nugget.
Do people toss around chicken nuggets? I don't know why I thought of that.
Anyhow... It's really important to understand the term because it's what drives real estate investing.
What Is Cash On Cash Return?
Cash on cash return is a fundamental concept for real estate investors. It is one of several ways to determine returns. It is related to, but different than the capitalization rate.
Cash on cash return is the cash return on the total cash you invested. It is calculated: (Cash Return / Total invested).
How to Calculate Cash on Cash Return
If you invested $20,000 into a rental property and it paid you $4,000 cash this year, then your Cash-on-Cash return is 20%. It does not include any equity pay down or appreciation.
It is entirely focused on your cash return based on the cash invested. Do not confuse cash on cash return for return on investment (ROI) or return on equity (ROE). Cash on cash returns are far easier to calculate, but they explain a different story to the investor than other return calculations.
Cash on cash return does not include any appreciation, depreciation, equity pay down, or other things that are have real effects on your net worth.
Here is a handy dandy cash on cash return calculator you can play with.
Cash on Cash return example #1
An investor buys a property for $100,000, puts $20,000 in work, and pays another $10,000 in carrying costs and closing costs.
The investor has put a total of $130,000 into the project.
If the investor turns around and sells it for $150,000 there is a total profit of $20,000.
This is a total return of 15.4%
Pretty straight forward, right?
Cash on Cash Return Example #2, a little more complicated
Let's say the investor above does the exact same deal, but this time borrows $100,000 from a lender and pays an additional $5,000 in interest. The total cost of the project is now $135,000 and there is a profit of only $15,000.
But, the investor has only put $35,000 cash into the project.
$15,000 / $35,000 = 42.9% cash on cash return.
Even though there is less profit, the rate of return is much higher.
Cash on Cash Return Example - Rental Property
Let's use the exact same property as the first example. The investor purchases the property and spends $130,000. The investor get's a conventional loan for 75% of the value, meaning the loan is for $97,500 and the amount of cash the investor spends is $32,500.
The investor rents the house out to a tenant. For simplicity let's just say PITI is 900, the expenses are $600, and the rent is $2,000. The total expenses are $1,500 and rent is $500 for a total cash flow of $500 per month or $6,000 per year.
$6,000 / $32,500 = 18.5% cash on cash return.
Cash on Cash return vs Return on Investment
This example will illustrate the difference between cash on cash return and ROI.
In the example above, you'll notice cash flow is rent minus PITI and expenses.
But part of that PITI actually goes toward principal pay down and will be recovered when the property sells.
Cash on cash return doesn't care about that. It just wants to know how much cash we put in the pocket compared to how much we invested.
You'll also notice that the property is actually worth $150,000, meaning $20,000 was earned right up front for a total equity of $55,000. Again, cash on cash return doesn't care about that equity.
Though the PITI for the year is $10,800, roughly $1,566 would be counted toward profits.
So, if after 1 year the house was sold, the income and expenses would look like this
- Rent: $24,000
- ITI + Expenses - $9,234
- Net Rent - $8,766
- Proceeds from Sale $20,000
- Principal Pay Down $1,566
- Total Profit - $30,332
ROI - 86.7%
If the house was sold in year two, it would look something like this
- Net Rent - $17,532
- Proceeds from Sale $24,500 (assume 3% appreciation)
- Principal Pay Down $3,200
- Total Profit - $45,232
Yearly ROI - 64.6%
You can see that the longer you hold it, the less your ROI becomes. It's because you take the fixed profit (value add equity) and divide it over more years.
As you can tell, ROI and Cash on Cash return yield different results.
Why It's Important To Know The Cash-On-Cash Return On Rental Properties
Cash on cash return tells you how much cash you are going to put into your bank account this year compared to how much money you took out of the bank at the beginning.
It tells you nothing more and nothing less.
Cash on cash is a simple and beautiful calculations.
ROI is extremely difficult because it needs to take into consideration cash flow, tax benefits, as well as equity or appreciation which you don't receive until after you refinance or sell.
The great thing about cash-on-cash return is it's cash in your hand.
If you can have a great cash on cash return, then any added appreciation or equity pay down is just a bonus.
What Is A Good Cash On Cash Return?
This is a hard question to answer because it depends on you.
Some people have a high risk tolerance and want a very high return. Others want safe but lower returns.
Many investors consider the return to be related to risk. A high return means a high risk. If a person is near retirement, they may want very little risk and thus prefer very low cash on cash returns.
Though risk may not be directly related to this measure, many people still treat it as such.
Some people may accept a low cash return in order to accept a high ROI based upon a value add deal. Others may care less about earning equity and just want a high paying investment right now.
The point is, it's impossible to really tell you what a Good Cash on Cash Return is because it depends.
What is more important:
IT'S IMPORTANT TO SET GOALS
Whatever your reasoning, set a goal and then achieve it.
If you want 10%, go for it. If you want 5%, go for that. Nobody can really tell you what is right or wrong because your own risk tolerance and investing goals are what is important to you.
If you want 10% cash on cash returns, great... just know that before running the calculator. If you don't have a plan, you may decide "alright, that's good enough." after punching the numbers in and getting a result.
Set your cash on cash return goals high
I believe it's important to set really high goals for your returns. With leverage, it's possible to exceed 20% or 30% ROI and easily have double digit cash on cash return.
Set high goals and if you fall short, you are still better than if you set low goals.