Are most investors calculating Cash on Cash Return wrong?

Question

I'm a serial entrepreneur that has owned and successfully run multiple businesses over the last 13 years, one of which has landed on the Inc5000 two years in a row. Scaling a small business to turn out a healthy profit is something I think about constantly, and analyzing an Income Statement and Balance Sheet is pretty normal for me.

As I have been looking to maximize my time and my talents I have become somewhat attracted to the economics of real estate. Part of the attraction for me is that it can be a "competition-free" business that can be somewhat passive if you wanted it to be. RE investing is just a diversification of my investment portfolio, and something I want to learn and be proficient at.

Before I get into any new business venture, I try and become as educated as possible so I'm not making mistakes as I go. As a relatively new investor in real estate, I've been consuming a LOT of content to learn from other people's mistakes and advice, and have begun modeling the financials of different types of properties with my own calculations. I currently own my own office building that my business rents from me, so I have a real-world example with real money and real taxes (applicable to my AGI).

As I have been building out my financial models, and comparing them to the BP calculator and other resources I have found online, I'm stuck on a concept that I wanted to ask here to validate whether I am thinking about this correctly. The concept has to do with how people are calculating cash flow, and cash on cash return.

What seems to me is that the BP calculator includes the principal payment as part of the "mortgage expense", when the principal is not an expense, and will not appear on the Income Statement for the property as an expense. Thus, the net income calculation is off by the amount of the principal payment.

It seems that the "cash on cash return" calculation is correct, because it's still taking the net cash generated at the end of the year. But, the "Total Annual Expenses" (OpX + Mortgage...aka Debt Service) would be incorrect because the Principal shouldn't be factored in.

As an entrepreneur, I look at ROCE (Return on Capital Employed), which is the total capital employed in the business, and how much income (not just cash) it spits out in return. Real Estate is much simpler because you can project a balance sheet easier than a business that is dependent on inventory turns that are somewhat out of your control if you don't own the manufacturing. All I'm trying to do is calculate ROCE, and I saw this as a potential flaw in the calculator.

I share this as it can drastically alter the perceived amount of return from an investment. Since most people compare investments to the general return of the stock market, most real estate investors seem fixated on the cashflow side of it, and rightfully so as many are trying to generate enough positive cash flow to sustain their lifestyle. But the inclusion of the mortgage principal payment as an expense could get people into hot water on their tax calculations, especially if they're reporting it to the IRS incorrectly.

Below is my example for the first operating 12 months. The ROCE / Net Income is 12.1% vs 6.4% when comparing it to Cash on Cash return.

Anyway, I'm open to learning more from you all, and please feel free to call me out on any calculations! I'm known to make some flubs in the numbers, and it's for this purpose that i'm sharing here to validate (or invalidate) what I've been working on!

Assumptions:

• Purchase Price: $150,000
• Down Payment: $30,000
• Closing Costs: $2,500
• Repair Estimates: $1,500
Capital needed: $34,000

_____________________________

Income: $17,100 ($1,500/mo with 5% vacancy rate)

_____________________________

Expenses: $12,990.40
• Mortgage Interest: $5,360.40 (per annum)
• Insurance: $900 ($75/mo)
• Taxes: $1,000
• Utilities: $420.00 ($35/mo)
• Landscaping: $600 ($50/mo)
• HOA: $1,200 ($100/mo)
• Management: $1,710 (10% of rents received)
• CapX/Repairs: $1,800 (10% of anticipated rents received)

_____________________________
_____________________________

Net Income / ROCE (before depreciation): $4,109.60
ROCE: 12.09%

Mortgage payment P&I (30yr, 4.5%): $ (608.02)
Mortgage principal payments made: $1,935.87

Cash on Cash Return: $ 2,173.73
Cash on Cash Rate of Return: 6.39%

Mike Dymski · Answer

COCR is just one metric. And it becomes irrelevant quickly after closing when ROE becomes more relevant. Cash flow is only one component of REI returns. Many investors use IRR to capture all components.

Joe Villeneuve · Answer

You're wrong on almost all of your assumptions as far a CoC and how the mortgage/principle factors in as they are applied to REI. What's funny here, is I find most REI don't treat REI like a business when running and analyzing the investment (money) side. You are applying the business side (understandably so based on your background) as if the business of REI is exactly like most normal business...which it isn't. I own my own businesses as wall as do a lot of REI, and although there are many similarities, there are more differences. I also find funny how many times you'll see people compare investing in the Stock Market to investing in RE, using direct % return analysis...which you can't do.First, CoC return involves nothing but cash. If it doesn't move as cash...don't include it. There's a reason it's called "Cash on Cash", and not "Cash on Cash w/(fill in the blanks here)". Another mistake made with CoCR is when you include anything other than the first year. CoCR is a measure of how cash your investment returns to you within the first year of your investment. THis is important because it tells the investor how quickly (and successfully) they can move their (cash) money through their investments, and how long it will take for them to recover their cost (what they physically put into these deals...in cash).When you are looking at return on your dollar, your mortgage payment (any part of it) shouldn't be included at all if you have positive cash flow. PCF means your tenant is paying your mortgage off, not you. Same holds true with taxes, insur., etc...anything that is paid from the rent payments.

David Acosta · Answer

I second @Mike Dymski's comments above. While Cash on Cash is a useful metric, IRR will round out the picture if you're holding the investment for longer than a year.

Spencer Boerup · Answer

Thanks for your perspective, I really appreciate it!I get that in a true COCR analysis, only count how much cash flow you have in the year. That's simply one analysis is all. But you'll end up paying tax on any "net income" you generated from the property.So from an Income tax perspective, the "net income" from the property is what you're paying taxes on, and because your principal payment from the mortgage isn't tax deductible, you'll end up with more net income than your free cash flow.So if you remove your depreciation (which is what I'm understanding makes REI so valuable) from your net income, then you essentially have your taxable income from that property. So the above examples that I gave had a net income of $4,109. If I can deduct depreciation of $5,454, which ultimately leaves me with a net loss. This essentially means I'm almost getting a tax refund in a roundabout way (assuming I have income from other sources).So the COCR, to me, isn't just the cash flow, because you'll have to rectify your income/losses with Uncle Sam, which absolutely impacts how much cash you have left over.