A Though on Cash on Cash Return

[Marc Izquierdo]

Hi everyone!  

I was recently playing around with the numbers on a duplex that I just finished up the rehab on and am in the process of finding tenants for.  While I was playing around, I had a question about Cash On Cash Return that I wanted to get some other investor's opinions on.

So mostly everyone knows that COCROI (Cash on Cash Return on Investment) is the cash flow you receive after all expenses divided by the total cash invested into the property.  However, I see some situations, more so in multifamily investments, where there are some grey areas with this simple equation.  For example:

Lets say you buy a SFR and after the down payment, closing costs, holding costs, and repairs it costs you $50,000 before you get a tenant in. If you're receiving $500 per month in cash flow after expenses ($6,000 per year), then your COCROI is $6,000/$50,000=12%. But my question is, at what point do you stop adding to that denominator? For example:

Say your property is up and running but one year you have to replace a hot water heater and an A/C unit and you end up losing $1,000 for that year.  Does that loss get tacked on to the denominator in the COCROI calculation?  So going forward, would you calculate your annual COCROI as Annual Cash Flow/$51,000?  I would think not.  I would assume that you would still take your cash flow for the year (which would be negative) over the original $50,000.

To expand on that though, say the original SFR example house is a multifamily property. With a SFR, it seems easier to calculate COCROI because there is a hard line as to where your initial investment (the denominator) ends (after the rehab is done and the tenant moves in). With a multifamily property, that denominator seems like it can sort of float and I cant seem to figure out when to stop adding capital expenditures to the denominator of the equation. For example, you acquire a duplex and one unit is vacant. Both units need to be rehabbed. So you leave the tenant in while you rehab the other unit. You finish the rehab on unit 1, get a tenant, and in total it costs you $10k. You move on to rehabbing unit 2 which again costs you $10k to rehab and get a tenant in. So your total capital expenditure cost during rehab was $20k. However, during the rehab of unit 2, a hot water heater goes out in unit 1 and will need to be replaced. Would that amount be included in the denominator of the COCROI calculation? Since the rehab is still on going but another CapEx item needs to be replaced, would you call that part of your "initial investment"? It seems like COCROI can be a bit subjective for multifamily. I wanted to get some opinions on this.

I was thinking of not including CapEx items (including the initial rehab) in the denominator at all and just call it negative cash flow. So the only things called my "initial investment", or the denominator of the COCROI equation would be the down payment, closing costs, and holding costs. So if the rehab took me one year and costs $20k (CapEx) and I had $50k in closing costs, holding costs, and down payment, my COCROI would be -$20k/$50k=-40% for that year. Then the next year (say I made $6,000 in cash flow), my COCROI would be $6,000/$50,000=12%. So in two years the Average Annual Return would be (-40%+12%)/2 years = -14%. Eventually we would get back to a positive percentage. So I'm thinking using something like that makes more sense? During the initial analysis (before buying the property) I would maybe drag out projections for 10 years to see what the Average Annual COCROI would be?

Sorry for the novel!  Hopefully this doesn't scare too many people off.  Let me know what you guys think!

Thanks in advance

Marc