Question on Cash on Cash Calculation

[Steffany Boldrini]

My mentor taught me to calculate the CoC with the interest only payments of the loan (not principal reduction). Now a friend of mine said it should include principal part of the payments on the CoC. Since commercial loans can be 20 or 25 yrs fully amortized, how is this a fair calculation? What would be a good CoC return for you? Should we indeed include the principal payment on the CoC calculation? Please only respond if you're 100% sure how this calculation is made, I've searched online and there's no clear answer. Thanks!

[Michael S.]

Hi Steffany,

"Cash on Cash" in the industry is a cash flow based metric, which would take into consideration the cash spent paying the interest AND principal. It is not a right or wrong thing; it is a metric that has a specific purpose and importance with understanding its weakness and strength just like any other metric.

It is a popular metric because cash flows speak to income focused investors. For this reason from my experience it is a metric older investors tend to focus more on. It’s generally only used for the first year or two of an investment (or the first stabilized year) as it fails to consider inflation/appreciation/time value of money…you comparing your equity injection 5 years ago to cash received this year isn’t a fair comparison ratio due to inflation.

It is a fantastic metric for those focusing on income producing properties. To oversimplify it, folks like it because it is simple. If its 4%, and they invest $100K, they should get $4K that year in their pocket regardless of the appreciation and loan pay-down that is taking place behind the scenes.

From my experience folks like 3% or higher in the first year of an investment (we aim for 4 to 5% for our investors). This of course is changing as interest rates are lowering, which is reducing the attractiveness of investors alternative choices, thus they are more willing to pursue a lower cash on cash return than they would have in the past.

Hope that helps.