You’ve spent weeks searching wherever possible. I kept an eye on the postings, sifted through what the brokers had to offer, and inspected several different homes. Because of your extensive familiarity with the market, you are certain that the property you have an agreement to purchase is dramatically underpriced compared to similar listings. The only thing that needs to be clarified is how much money you stand to gain from this transaction.
Profits for real estate investors can be calculated in various ways, depending on the situation. To conduct an accurate business transaction analysis, investors will often use more than one measure or indication. Certain metrics are more applicable in different settings or when viewed from a specific vantage point.
This article’s objective is to analyze “cash on cash return,” how it is calculated, and the circumstances in which it is employed in the context of financial investments. Whether you’re considering passive or active real estate investment prospects, cash on cash will always be an important measure to analyze.
Real Estate Cash on Cash Return 101:
Cash on cash is one of my go-to methods for swiftly evaluating a property investment. It’s simple to compute and helps you quickly and easily evaluate and choose among investment options.
Understanding the Formula for Cash-on-Cash Real Estate Return (No Debt)
Cash on cash is determined by dividing cash flow before taxes by total cash invested. Consider a $1,000,000 all-cash purchase with a $100,000 annual salary in the first year. Without leverage (debt), the cash on cash return is 100,000/1,000,000 =.1 = 10%. It’s a straightforward computation and can easily compare properties or investments in different asset classes.
The Formula for Cash-on-Cash Return (With Debt)
Using debt and mortgages as leverage is a great way to increase your investment returns in real estate, as evidenced by the cash on cash return after debt. Consider the identical scenario as before, except this time you decide to finance the purchase of the property by taking out a loan for $800,000 and putting down a down payment of $200,000. You and the bank have agreed upon a payment schedule, and each month you will pay $5,000.
Instead of $100,000, you have $50,000 of free cash flow left over. However, you just put in $200,000 of your own money this time. Therefore your cash on cash return is 50,000/200,000 = 25%.
Although the statistics have been reduced for clarity, you can still appreciate the potential of debt and its implications on cash-on-cash return in the grand scheme.
Cash on Cash Boundaries:
When comparing investment options, this statistic ignores the varying risk associated with each asset. It does not reveal if the predicted superior returns of new ground-up development or a “war zone” multifamily are worth the accompanying risks compared to purchasing a triple net leased credit tenant retail property. Without considering the higher risks associated with, the higher returns, an investor cannot arbitrarily decide that an investment offering a return of 12 percent cash on cash is better than one offering a return of 6 percent cash on cash.
The appreciation and depreciation of the property, which can differ from one piece of real estate to the next, are not taken into account in this simple calculation. The cash on cash return formula does not consider the equity you have built up in your home due to mortgage payments that go toward the principal.
Extending the time frame, especially when considering shifts in the income stream, is another instance where cash-on-cash doesn’t give the complete story. For example, think about the same property as previously, but this time calculate the income from year two. Let’s say you negotiated a rent increase into your contract, and now you’re bringing in $200,000 before interest and taxes in year two. You can miss a lucrative chance if your purchase criteria exclusively consider immediate cash on cash returns. A discounted cash flow analysis is more appropriate for examining returns over several years. Discounted cash flow is a topic for another entry.
Final Thoughts
The cash-on-cash return for real estate is an extremely useful instrument for swiftly evaluating an investment’s desirability. Nevertheless, it would be best if you didn’t base your judgment on this factor alone when investing. Instead, cash on cash returns should be utilized as a screening method to determine whether or not an investment is worthy of additional examination and analysis.
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