Cash-on-Cash Return: What It Is, Why It Matters, and How to Calculate It

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This article should not be interpreted as financial advice. Always seek the help of a licensed financial professional before taking action.

When you’re new to real estate investing, it feels like every other term you hear is lingo. Investors throw around terms like “cap rates” and “turnkey properties” and “prorated rent.”

It’s downright overwhelming at times. Almost like learning a second language.

Fortunately, most of the concepts are extremely simple. And one of the easiest of all is the cash-on-cash return.

What Are Cash-on-Cash Returns?

In short, the cash-on-cash return is the money earned on the actual cash you invested into a property.

You can measure the returns on any kind of real estate investment: flips, rental properties, raw land, mobile homes, you name it. That’s because they’re ultimately just a ratio of two numbers: how much cash you invest vs. what you get back in earnings.

For example, if you put up $10,000 of your own cash to buy a property, and your net gain for the year (the money you actually pocketed) is $1,000, then you’ve earned a 10% cash-on-cash return.

It’s that simple.

Well, kind of.

People love to complicate things when they talk about returns, and to be fair, there are many ways of calculating “return on investment” for investment properties.

But cash-on-cash return (often abbreviated to CoC return) is the most straightforward way to measure the success of your investment.

Why Cash-on-Cash Returns Matter

Cash-on-cash returns provide insight into what you can expect to earn for your money, whenever you buy an investment property.

It’s worth noting on interesting thing – the purchase price of the property is nowhere in the calculation.

Unlike cap rates, the formula for cash-on-cash return is based on what actual cash you plan to invest, based on your financing terms (cap rates ignore financing entirely, and only measure the property’s price and income potential.)

Another difference between cash-on-cash returns and cap rates is that cap rates are only useful for comparing income properties. But because cash-on-cash returns measure any type of profit, not just income, they let you compare the return of a real estate deal to other types of investments.

For example – let’s say you have $10,000 to invest, and you’re trying to decide whether to invest it in an S&P 500 index fund or a rental property. You look at the average returns of the S&P 500 over the last 80 years and see that it was around 10%, including both dividends and capital growth.

Then you run the numbers on the rental property, and determine that after expenses, the property will yield around a 10% cash-on-cash return in rent revenue alone. You decide to proceed with the rental property, knowing that appreciation will likely push your total return higher than the 10% offered by the S&P 500 (and also because rental cash flow is more predictable than stock returns, but that’s another conversation).

Alternatively, you can compare the cash-on-cash returns for two properties. For example, you may determine that in your market, it’s extremely difficult to find a rental property that yields more than a 4% cash-on-cash return. But you find another market where you can buy rental properties that yield 10% cash-on-cash returns. It’s one reason why more investors are looking further afield to buy real estate long-distance.

How to Calculate Cash-on-Cash Returns

The math behind cash-on-cash returns is both elegantly and deceptively simple. Here’s how it looks:

Expected Net Profit (either one-time or annually)

______________________________________________________

Required Cash Investment

Easy enough, right? An $800 profit divided by a $10,000 cash investment means an 8% return.

The trouble is, many investors miscalculate one or both numbers. For example, what looks like an 8% return when you buy could turn into a -10% loss, if you start renovating only to discover that the renovation will cost twice as much as you estimated.

Things can also go sideways if the property sells for less than you expected, or rents for less, or if the vacancy rate proves higher than expected, or any number of other unexpected problems.

So while the math is easy, plugging in accurate numbers is often a challenge for investors. Here’s how the numbers can play out as you estimate your returns.

What Affects Cash-on-Cash Returns?

The short answer is that cash-on-cash returns are affected by your costs and your revenue.

If you lower your costs or increase your revenue, you’ll earn a higher return.

If you increase costs or lower your revenue, your return will drop.

For example, if you buy a property for $100,000 to flip, financing $90,000 of the purchase price. You would invest $10,000 of your own cash as a down payment and pay another $2,000 out-of-pocket in carrying costs.

Upon completion, if you sell the property for $160,000, and after all rehab, financing and closing costs are paid, walk away with a $6,000 profit.

You just earned a 50% cash-on-cash return:

$6,000 earned / $12,000 cash invested = 50%

But what if you sold the property for $155,000 instead, walking away with only $1,000 for your troubles? That lower profit puts your cash-on-cash return at around 8%.

$1,000 earned / $12,000 cash invested = 8%

Every expense affects your cash-on-cash return, because it’s all presumably coming out of your pocket and NOT being financed with OPM (other people’s money). Property taxes, insurance, repairs, maintenance, closing costs.  If you buy a rental property, your vacancy rate and property management expenses eat into your returns.

The silver lining is, you actually have some control over many of these expenses. For instance, you can reduce your repair costs with preventative maintenance.

Then there’s the elephant in the room that affects your cash-on-cash returns: your financing terms.

How Financing Impacts Cash-on-Cash Returns

One of the great advantages that real estate has over other types of investments is leverage. You can use other people’s money to accumulate your own assets, wealth, and sources of ongoing passive income.

In the example above, the investor earned a 50% cash-on-cash return flipping a property over the course of a few months. That kind of return and turnaround time are unheard of in most other investments, and leverage is what makes it possible.

Of course, financing not only reduces your cash investment, but it also raises your expenses. Every extra dollar you borrow means higher interest and fees.

Consider a rental property example. You buy a rental property for $100,000 CASH and rent it for $1,200 a month. Let’s assume your non-mortgage expenses come out to $500 per month ($6,000 annually), including everything from vacancy rate to property management fees to taxes to repairs to insurance. For the sake of simplicity, we’ll ignore closing costs and say you got a seller concession to cover them.

Without financing, your annual net revenue comes to $8,400 ($700 a month X 12 months). That means a CoC return of 8.4%:

$8,400 earnings/$100,000 cash investment = 8.4%

That’s a solid return that most investors would embrace.

Now, imagine you finance the purchase of this property, borrowing $80,000 at 7% interest for a 30-year loan. Instead of coming up with $100,000 in cash, you only invest $20,000, but now you’re also saddled with an additional monthly expense of $532.24 for the mortgage payment.

This brings your monthly cash flow down to $167.76, putting your annual profit at $2,013.12. This changes your cash-on-cash return changes to 10.07%:

$2,013.12 earnings/$20,000 cash investment = 10.07%

This indicates that even though your annual return is lower, your smaller $20,000 cash investment is still working harder than if you had purchased this property without any financing at all.

And don’t forget – your options for leverage aren’t limited to mortgages. Try one of these creative ways to fund your next real estate deal.

How Can I Improve My CoC Returns?

As outlined above, one option for improving your cash-on-cash return is to finance your investment properties.

If you’re financing your properties, keep in mind that changing the financing terms will also impact your cash-on-cash returns.

If you borrowed the mortgage above at 6% interest instead of 7%, your monthly payment would drop to $479.64, leaving you with an annual profit of $2,644.32 and a CoC return of 13.22%.

Likewise, if you negotiated a lower down payment of 10% (or even 3.5% with an FHA loan), your cash-on-cash return would be even higher. Granted, your earnings would be significantly lower… but the simple measure of how hard your cash if working for you would increase, because your total cash investment is a much smaller number.

Another way to improve your cash-on-cash return is by reducing expenses. For example, rental investors can reduce their vacancy rate and repair costs by avoiding horrible tenants. And far too many new investors make the same few mistakes; boost your returns by avoiding these expensive real estate investing mistakes.

You can also boost CoC returns by paying less for the property in the first place. Try these negotiation techniques to get a better deal on your property purchases.

Alternatively, you can raise your revenue. Look for ways you could lift the asking price for flips, or the asking rent for rentals. What amenities are hot right now in that market? What could you do to attract higher-end buyers or renters?

These fundamentals apply to every type of investment: buy for as little as possible, keep your expenses low, and sell or rent for as much as possible. Conceptually simple, but it takes experience to master the execution.

Where New Investors Go Wrong in Forecasting CoC Returns

New investors tend to get overly optimistic when forecasting their cash-on-cash returns, by underestimating expenses and/or overestimating the resale price or rent amount.

For flips, new investors often underestimate repair costs and carrying costs. All too often, renovation projects go over budget or beyond their expected timeline (or both), leaving the investor holding the bill for loan payments, utility costs, taxes, and other carrying costs. Lost time is literally lost money in a property flip.

New rental investors tend to underestimate vacancy rates, property management costs, and ongoing maintenance and repairs. Many tell themselves fairy tales like “I don’t need to budget for property management; I’ll manage the property myself!”

Which is all well and good until they take a job in another state, or have triplets, or realize they hate managing rentals.

Always use conservative numbers when forecasting your expenses and revenues, to avoid nasty surprises in your CoC returns. In particular, keep an eye out for these all-too-common real estate number-crunching errors.

How Are CoC Returns Different from Cap Rates?

While we touched on this above, it’s worth a more detailed explanation.

Cap rates ignore financing and are based on the raw property numbers. A property’s cap rate is universal, regardless of who buys or owns the property.

But your cash-on-cash return is unique and specific to you. It’s based on how you choose to finance the deal, how well you manage the property, how well you can market it, and so on.

Keep in mind that cap rates only apply to income properties, such as single-family rentals, apartment buildings, or rented office buildings. They’re useful for comparing two income properties, but it can’t be used to analyze other investments.

In contrast, you can apply cash-on-cash return to any investment, real estate or otherwise.

What’s a “Good” Cash-on-Cash Return?

That’s a loaded question if I’ve ever seen one. But a valid one nonetheless.

I personally use the S&P 500 as a benchmark for returns. Over the long-term, I can earn 7% – 10% by parking money in an index fund and leaving it alone. No work required, no headaches, just long-term growth.

When I invest money in rental properties, I expect to see at least comparable cash-on-cash returns. And since rentals do require ongoing management, I’m very careful to include generous property management expenses in my return calculations. Otherwise, you’re comparing apples to oranges when comparing a completely passive investment with one that requires labor.

I also ignore appreciation in my CoC return calculations for rentals. I consider it a bonus, and compensation for some of the downsides and risks associated with owning real estate (such as poor liquidity and diversification).

Flips require a different calculus. The raw cash-on-cash returns for flips can be outstanding, often 100% or higher for an investment held for just a few months. But they take significant labor on your part, so you must find a way to account for the time and effort spent.

RELATED: How Much Should You Offer For That Property?

One option is setting an hourly rate for yourself, and estimating your labor hours required from start to finish. Another option is to outsource the labor to an assistant or general contractor – just make sure you don’t end up spending as much time overseeing your contractor as you would have overseeing the project yourself.

Final Word

Cash-on-cash returns make for a simple and effective way to analyze and compare any investment, real estate or otherwise.

But they can also be deceptive, particularly when it comes to the cost of labor, time, and headaches. You can earn a great financial return on a flip, and easily waste hundreds of hours of your time in the process.

Likewise, low-end rental properties can look great on paper, promising excellent cash-on-cash returns. Yet experience has taught me they come with hidden headaches and expenses that aren’t easy to anticipate.

As a new investor, be conservative in your expense and revenue forecasts to avoid surprises. Most of all, educate yourself on oft-overlooked expenses, and get as much feedback from similar investors as you can.

Don’t reinvent the wheel – learn from others’ expensive mistakes, so you can earn high returns from your very first investment property.

What kind of cash-on-cash returns do you look for in your real estate investments? Where have you gone awry in forecasting CoC returns in the past? Let us know in the comments below!

The post Cash-on-Cash Return: What It Is, Why It Matters, and How to Calculate It appeared first on REtipster.

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