When it comes to real estate investing, thoroughly underwriting potential investment opportunities is critical in making sure you are investing in the right deals.
You should perform a few essential calculations to gauge the profitability of an investment opportunity, one of those being the cash-on-cash return.
The cash-on-cash return formula and other vital metrics will help you analyze your next investment opportunity more strategically, bringing you better profits!
This article will give you the ins and outs of the cash-on-cash return metric and why it is essential.
What is Cash flow?
Before we get into the cash-on-cash return, investors must understand the term cash flow.
Cash flow is essentially the total profit you bring in from an investment after paying your operating expenses. Cash flow may also be referred to as passive income.
In commercial real estate, you may also hear the term cash flow investor.
Cash flow investors refer to investors whose investment strategy is to increase income and decrease expenses to improve their monthly or annual cash flow. Keep in mind this strategy would differ from investors whose primary goal is long-term equity appreciation.
What Is Cash on Cash Return?
The cash-on-cash return formula is commonly used in the commercial real estate space to help calculate the amount of income you earned on a given investment, assisting investors in interpreting how much cash flow they will receive from an investment opportunity.
The cash-on-cash return formula looks at the amount of cash you invested in a project compared to the amount of income you received over a specific period. Let’s take a look at the cash-on-cash return formula below.
Cash on Cash Return Formula
The cash-on-cash return formula is calculated by taking the annual income, and the total cash invested. Let’s first walk through finding each part of these two equations to plugin to the cash-on-cash return formula.
Cash on Cash Return: = (Annual Cash Flow / Initial Cash Investment ) x 100%
Step 1: Finding Your Annual Cash Flow
Your annual cash flow is a calculation that shows how much rental income you have left after all of your property’s expenses has been paid. In Multifamily Real Estate, here are just a few of the expenses you may across.
- Asset Management Fees
- Property Management Fees
Once you identify your monthly cash flow by subtracting your expenses from your income, you will multiply this figure by 12 to find your annual cash flow.
Step 2: Identifying Your Total Cash Invested
When it comes to the total cash investment, you must know that it is the amount of cash that you have invested in the project. This does not include the leverage or debt you get from external sources.
Once we have identified the total cash outlay and annual cash flow of the asset, we will use the cash on cash return formula.
Cash on Cash Formula Example:
Jane purchases an $850,000 multifamily property and contributes $180,000 with her 20% down payment and closing costs. No repairs were needed before she leased the units, making her initial cash investment was $180,000.
Let’s say Jane began to earn $6,000 per month with $5,000 in expenses, including vacancy, maintenance, mortgage payments, etc.
This leaves Jane with $1,000 in monthly cash flow. Multiplying her monthly cash flow by 12, we see Jane’s annual cash flow would be $12,000.
Plugging the annual cash flow and the initial cash investment into the cash-on-cash return formula, we see that Jane is earning a 6.7% cash on cash return on her multifamily property!
What Is Considered As A Good Cash On Cash Return?
Most commonly, a “good” cash-on-cash return in multifamily real estate will range from 7% to 12+%.
However, although cash on cash return may be considered good, multiple factors need to be considered alongside it.
Restricting good cash on cash return to the 7 to 12% range isn’t always the case. You will need to analyze various metrics such as the NOI, the DSCR, the cap rate, IRR, and more when analyzing an investment opportunity.
Pros And Cons Of Cash On Cash Return
Every return formula has its pros and cons, and so does the cash on cash return formula. Let’s have a look at what these are.
When it comes to cash-on-cash return, you get a quick snapshot into the cash returns that a real estate investment provides. This helps investors quickly analyze an investment offering and if it fits their investment criteria.
There is limited data used to calculate the return, which might not be adequate when analyzing an investment opportunity.
The cash on cash return is highly used across the real estate industry as it provides valuable information to investors!
The cash-on-cash return formula is a great way to get a quick snapshot of your return on your cash investment, especially when you need to communicate with shareholders!
It’s also a great way to see how much operational costs are cutting into your returns.
Keep in mind that the cash on cash return formula is not the only formula that should be utilized when underwriting your next real estate investment.
It is crucial to consider the use of other metrics such as the internal rate of return, capitalization rates, the loan-to-value ratio, and more!