What Is Cash-On-Cash Return & How To Calculate It

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Cash-on-cash return is one of the most important return on investment (ROI) measurements in real estate. Fortunately, it’s also very easy to understand. Quite simply, a cash-on-cash return is the amount of income made on a property annually in relation to the amount invested into the same property, usually through mortgage payments. 

Cash-on-cash return is also understood as the cash flow rate on a real estate investment, that is, the amount of pre-tax income on an investment vs. the amount invested the same year. Cash-on-cash return rates are often used as a tool for forecasting real estate income and expenses. Cash-on-cash returns are measured in percentages.   

Related: The Top 8 Real Estate Calculations Every Investor Should Memorize

What is Cash-On-Cash Return?

Cash-on-cash return is the rate at which cash income is made on a real estate investment. It’s calculated in percentages and is used as a tool to calculate annual earnings (cash flow) on a property investment. In evaluating the cash-on-cash return, annual cash flow plays a pivotal role.Working out the cash-on-cash return ratio (CRR) is often recommended by real estate experts as a way to decide whether a real estate investment is worth it. The CRR can indeed help you figure out the long-term performance of a property investment, but, as we’ll see, it’s not the only tool you should use for an accurate prediction of your ROI.

How to Calculate Cash-on-Cash Return

Learning how to calculate cash-on-cash return is simple. We simply divide the received net cash flow for the year by the amount of cash invested.

Not too bad, right? However, it’s the variable annual pre-tax cash flow, and actual cash invested that can be tricky.

Understanding annual pre-tax cash flow

Calculate your annual pre-tax cash by adding together the following:

• Gross scheduled rent: The property’s gross rents multiplied by 12. This reflects the maximum amount of income you can expect to receive.
• Any other income: Think about all of the other earning opportunities the property may present. Will you allow pets and receive pet income and non-refundable deposits? Do you have parking spaces available? Do you get reimbursed for utilities or charge a flat rate regarding such?

Then, subtract:

• Actual vacancy: If you already own the property and want to produce the cash-on-cash return to understand your property’s performance, you will want to use actual vacancy here. The actual vacancy should be measured by the number of days your property was vacant multiplied by the daily rental rate. Otherwise, use potential vacancy — which should always be a conservative number. Multiply your vacancy rate by the gross scheduled rent.
• Operating expenses: This ranges from insurance, taxes, maintenance, HOA and bank fees, property management, and repairs.
• Annual debt service: For the purposes of learning how to calculate cash-on-cash return, this number will be your monthly payment to cover both principal and interest related to your loan. This does not include insurance and taxes.

Related: Cash Flow vs. Equity: Which Pays Off for Investors in the Long Run?

Calculating actual cash invested

Now let’s calculate the actual cash invested. Combine these numbers:

• Down payment: Simply the amount of money you pay to obtain the property.
• Closing costs: Add up your net closing costs associated with obtaining the property. To do this, add up all of the costs you paid (not including your down payment) and then subtract from that any seller or lender credits given to you.
• Pre-rental improvements and repairs: Pre-rental improvements and repairs include anything you pay out-of-pocket to fix prior to renting the units out. (This is the part where the cash-on-cash return metric loses some value — it doesn’t do a good job of analyzing returns when you are injecting more cash into the asset after renting out the property).

Example of calculating cash-on-cash return

Let’s take a simple example: you have invested $1,000,000 in a property with an annual pre-tax cash flow of $100,000. Now let’s apply the formula for working out the cash-on-cash return to these numbers:

100,000 / 1,000,000 = 10.00%  

That’s it. Your cash-on-cash return is 10%.

What is a Good Cash-on-Cash Return Rate?

What is considered a “good” cash-on-cash return rate always depends on local housing market conditions. Real estate investors often utilize cash on cash calculations to assess the performance of their investments.In general, a rate of 8-12% is considered good by both real estate investors. However, in challenging real estate markets, a rate of 5-7% is considered to be acceptable. By contrast, in hot housing markets, a real estate investor might choose not to consider investment properties unless they will deliver a cash-on-cash return rate of at least 15%. 

Cash-on-Cash Return vs. ROI — What’s the Difference?

Sometimes you’ll see the terms “cash-on-cash return” and “return on investment” used interchangeably, but they’re not actually the same. An ROI, or return on investment, refers to the rate of return on the total amount invested in a property, which includes the cash invested. What’s meant by “cash” here is the equity held in the property. There are other elements of a real estate investment that contribute to the ROI, such as any renovations undertaken. Cash-on-cash return refers strictly to the rate of cash return on the cash invested on the mortgage of the property. Evaluating the cash yield as well as the net operating income can help determine the profitability of your potential investment property.

Why Cash-on-Cash Return Is a Bad Metric

Despite the fact that this metric provides an effective back-of-the-napkin calculation, investors shouldn’t rely on this number.

1. It doesn’t indicate your actual return

Did you really think you were going to get through an entire article — written by a CPA — without discussing taxes?

Your unique tax situation significantly impacts your actual return on investment. However, some investors argue that your tax situation doesn’t impact the asset’s performance — it is independent of you. They believe taxes should not be taken into account.

However, the tax impact of investment decisions should absolutely be assessed. Your tax situation may not impact the asset’s performance, but the asset’s performance directly or indirectly impacts your tax situation, and that affects your returns.

Let’s say your annual pre-tax cash flow is $10,000, and you have invested $100,000. That’s a 10% cash-on-cash return. However, if you are in the 25% tax bracket, your after-tax cash flow is $7,500 — a 7.5% actual return.

Further, we have to consider depreciation and amortization. In the example above, if your depreciation and amortization amount to $8,000 annually, then only $2,000 of the cash flow will be taxed, making our tax liability $500, assuming the same 25% rate. Since depreciation and amortization are “phantom” expenses, our after-tax cash flow is $9,500, resulting in a 9.5% actual return.

2. It doesn’t account for equity

Yet another wrinkle: This metric doesn’t take into account the equity added from the principal portion of your loan payment. That means it also assumes the entire mortgage payment is an expense. However, the principal portion of your loan payment can’t be expensed for tax purposes.

As you can see, because the cash-on-cash return uses pre-tax numbers and doesn’t account for principal payments, the return suggested should not be trusted.

3. Additional limitations

• Cash-on-cash return doesn’t take appreciation into account. That’s why cash-on-cash return is best used for value investing, not speculation. Depending on how you invest, this could be a good or bad thing.
• It ignores the risk associated with investments.
• This metric doesn’t take opportunity costs into account, which more sophisticated investors will find alarming.

It also ignores the effect of compounding interest. Cash-on-cash return may make short-term investments look more appealing and make longer-term investments with a lower cash-on-cash return unappealing. But someone interested in an investment that compounds or appreciates may be better off taking the investment with a (currently) smaller cash-on-cash return.

Related: Don’t base your buying decisions on cash-on-cash returns alone

When Investors Should Calculate Cash-on-Cash Return

Much of the real estate industry, including investors and agents, use cash-on-cash returns. Why? Because of the metric’s simplicity. Here are some times you should calculate this percentage.

1. If you’re determining how much financing to use

This number specifically drills down to the return on the capital invested. It only considers returns that are driven by the property’s net cash flow and doesn’t take asset appreciation into account.

Because cash-on-cash return only compares net cash to the actual cash invested, it’s a great way to assess the effect of leverage so you can measure different levels of financing. Using leverage decreases your cash-on-cash return.

2. If you’re looking for a simple rule of thumb

Many investors are not sophisticated enough to use things like the internal rate of return (IRR) or modified internal rate of return (MIRR). These two metrics can be difficult to learn and understand. Yes, they provide more insight — but also require more work.

It’s easy to understand how to calculate cash-on-cash returns. It’s simply the physical cash you have in hand after 12 months, divided by the physical cash you’ve invested. Because of that simplicity, it’s also a great way to run a “back of the napkin” analysis, which I personally use to screen potential deals quickly. The calculation takes 10 minutes or less and typically gets you within 2% – 5% of the actual return on equity.

If you’re analyzing hundreds of deals a week, something like this makes a lot of sense.

However, if you want more accurate results, use other metrics to supplement the information that the cash-on-cash return provides — specifically, the IRR and MIRR. While these two metrics require a bit more work, they also offer more insight into the property’s performance.

3. If you’re comparing multiple investments

Cash-on-cash return also allows you to compare different investments easily. You can compare rental property to lending, determine whether you should invest in stocks or bonds, or if you should start a business. Granted, it doesn’t consider risk factors, but the cash-on-cash return does allow for a universal comparison between different investments. 

4. If you’re in your first year of investing

Cash-on-cash return can be a useful tool to evaluate or project the property’s first-year performance. After that, the cash-on-cash return begins to lose value because your denominator — the actual cash invested — will constantly change as you pay down the loan and make improvements and repairs. In this situation, I recommend using IRR.

Conclusion

While the cash-on-cash return certainly has weaknesses, it’s a great metric for value investors and serves as a solid screening tool. Using it in tandem with other metrics will give you plenty of information to place an offer on a property. By incorporating cash on cash calculations, analyzing the cash yield, and net operating income, investors can make informed decisions.

How often do you use the cash-on-cash return formula when evaluating properties?

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.