Attend any real estate networking event and you’ll likely hear a bunch of real estate jargon and acronyms floating around the room like ‘cash-on-cash return’, ‘cap rate’, IRR, and ROI. As a real estate professional, you thought you understood these terms, but you’d love a handy guide with the most important one explained in plain English.
This guide will unpack one of the most popular financial metrics used by commercial real estate investors to measure the returns on an investment property: cash-on-cash return.
- The plain-English definition of cash-on-cash return and how it’s calculated
- Why it’s important to understand cash-on-cash return and other real estate return metrics
- How you can use cash-on-cash return to make good investment decisions
What Is Cash-on-Cash Return?
‘Cash-on-cash return’ is a measure of the income earned on the cash invested into a commercial real estate deal. It is calculated by dividing the annual cash flow from the property by the amount of actual cash invested. Cash-on-cash return is expressed as a percentage.
Investors can use this metric to easily compare business and investment opportunities against each other. A higher cash-on-cash return means a better investment.
Cash-on-cash return is also referred to as ‘cash yield’.
How to Calculate Cash-on-Cash Return
The formula for calculating cash-on-cash return is:
Cash-on-Cash Return = Annual Before Tax Cash Flow/Total Cash Invested To-Date
Calculating cash-on-cash return doesn’t have to be difficult. There are several online cash-on-cash calculators that you can use to make your life easier.
Example 1: An Investor Puts in a Down Payment of $200 000 on $1 Million Loan
An investor uses a bank loan to buy a property for a grand total of $1 million. To get that loan, the investor had to put $200,000 in as a down payment (this is his cash investment). The property produces an income of $50,000 per year (after paying all expenses except taxes), making the profitability (ROI) 5%.. So, given that the annual 'cash income' is $50k and the 'cash investment' was $200k, the cash-on-cash return for this investment is 25% ($50k / $200k = 0.25).
Example 2: The Investor from Example 1 Reduces Their Down Payment
What if the investor from Example 1, only had to put in $100k as a down payment instead of $200k? Their cash-on-cash return would be 50% instead of 25%! That's doubling the return for the investor even though the profitability (ROI) of the property remained exactly the same at 5%. If someone only relied on the ROI metric, then they would miss the huge potential gains offered by reducing the down payment amount!
To summarize, the cash-on-cash return is simply the percentage of income you make on the actual cash you take out of your pocket and put to work (your cash investment).
Why Real Estate Return Metrics are Important
Many investors are wading their way through hundreds of potential real estate deals before making a decision. Financial metrics like cash-on-cash return provide an ‘apples to apples’ comparison that helps them to assess the financial value of the deal and make decisions more easily and quickly.
Anyone and everyone who touches a real estate deal should have a basic understanding of certain key return metrics relating to the property they are interested in. Apart from cash-on-cash return, other real estate return metrics include Cap Rate, Internal Rate of Return (IRR), Return on Investment (ROI), and Equity Multiple (the same as ROI but different units).
Ultimately, you are investing in real estate to make money, and so knowing the metrics helps you to assess how much money you will make from each deal. Some investors require a metric to hit a certain number before they even consider pursuing a real estate deal.
Aside from investors, it’s also important that governments (local and national) understand these metrics so that they know what potential businesses and employers are looking at, otherwise they don't know how to entice investment or optimize other economic aspects of their city.
Benefits of Measuring Cash-on-Cash Return for Commercial Real Estate
In some ways, cash-on-cash return is the most important return metric of them all, because it offers the simplest way to understand how much money you make on the cash you invest, and that is how most people tend to think about their finances and investments.
For example, if you had a total of $100k in personal savings sitting in the bank, a question you might ask is: How much money can I actually make by investing this $100k? Cash-on-cash return answers that question for you, whereas the other return metrics may miss the mark.
There are other benefits to using the cash-on-cash return metric which include:
Cash-on-cash return allows investors to do a do quick comparison of potential real estate deals based on the financial information provided by the seller.
Factoring in the cost of financing
Unlike other real estate return metrics, cash-on-cash return includes allowance for debt and/or mortgage costs. So, if a property involves long-term debt borrowing, as is common with commercial real estate transactions, you’re able to calculate the actual cash return.
Gaining insights into a property’s expense profile
Properties with high expenses generally have lower cash-on-cash returns. These kinds of insights help investors to analyze and compare the advantages of potential deals, and also to look at ways to bring property expenses down.
Final Thoughts on Cash-on-Cash Returns
Commercial real estate investing can be a complex and competitive environment to navigate. Investors make guesses and assumptions as to the types of things that would be conducive to a strong investment - such as using a key investment metric like cash-on-cash return.
However, it’s not easy to find and identify good opportunities. That’s why having the right tools to help you discover and analyze opportunities can be very helpful.
GIS analytics tools like AlphaMap allow people to hunt for opportunities based on their assumptions. Additionally, these tools help people see patterns and opportunities that they wouldn't have known otherwise.
Ultimately, it’s important to evaluate your investment decisions within a wider context of other investment return metrics, and available data. You won’t get all the answers from one metric only, but cash-on-cash return is indeed a good measure to start with!