Cash on Cash Return Compared to Cert. of Deposits

[Llewelyn A.]

While I have been a RE Investor for 2 Decades, I've seen this metric quite often. The Cash on Cash Return (CoCR) seemed to be part of a lot of REI's decision making criteria.

This Post will be a very long one but one filled with Calculations. Any errors, please let me know and if you are willing to read and analyze it all, I really respect that! I'm a geek at these things and I get carried away.

To fully understand it, I wanted to start this discussion and present various Calculations, but project them out to 10 years. That way the General BP community can help me sort out how this Metric is used and whether there are any drawbacks. One of the issues I have with the CoCR is that it's a calculation based only on the 1st year ownership. I hope to expand on this.

I normally use a Certificate of Deposit (CD) as a comparison tool because the Calculation is very easy AND anyone can Invest in a CD. To start it out, I wanted to show this Calculation for someone who will put $30k into a CD for a holding period of 10 years.

Today's Rate as of 12/7/2016, you will see 10 Year CDs are around 1%.

The way this a CD works is that you would deposit your money in to the CD, let it sit there for 10 years, then your money will compound by reinvesting the Interest along with your principal over a 10 year basis. So you make Interest on your Interest!

The calculation for a 10 Year CD at 1% Fixed Annual Interest Rate looks like this:

Now that we have the calculation referenced in terms of today's safe investment by using a CD (yes, we can use Treasury Bonds, but the average person probably doesn't even know how to do that), we can benchmark possible Investments using BOTH in order to get the equivalence.

As a Stock Example, let's say you were to buy a bunch of stocks and you Invested $30k total for all the stock you purchased. If after 10 years the Stocks you purchased is worth $40k and you sold it for that, we can build a CD EQUIVALENT.

Here is the EQUIVALENT CD Calcs for the Stock Investment example:

You can see that the Equivalent CD Rate of that Stock Investment is actually 2.92%.... which is much better than the 1% in the previous Example for the straight CD.

So, why do we need this kind of Comparison? Because it should not matter WHAT you invest into (Stocks, CDs, Real Estate, Business, etc.) AND How much you have INVESTED. What Matters is what we call the RATE of RETURN or RoR which is what is being measured here.

So, let's take an other example, this time with a Real Estate Investment. Let's say that you invested $50k in a DUPLEX, you did not receive ANY cashflow but were completely EVEN, neither receiving Cashflow or paying out of pocket above the rents for any repairs or expenses during your 10 years holding period. However, after you sold the property, you received $65k in Cash from the Sales Proceeds.

The Calculations will look like this: 

So, you will notice that the CD Investment gives you a profit of $3,139, the Stock Investment gives you a profit of $10k and the RE Investment a profit of $15k.

HOWEVER, the RoR are different. The CD is a 1% RoR, the Stock is a 2.92% RoR and the RE is a 2.66% RoR.

Which is better? Clearly the Stock investment because the RoR is the higher of all 3. The fact that the REI had a $15k profit versus a $10k profit for the Stock Investment does not make the REI a better investment. All you had to do was to bring up your initial investment in the Stock Investment and you would get a higher profit than the $10k. It will be higher than the $15k if you had invested the $50k in the Stock Example versus only $30k.

Moving on to the Cash on Cash Return (CoCR).... This is a more detailed example so we can look at the calculations and translate it into the CD Comparison so we can make comparisons to all Types of Investments:

Now, there are certain assumptions that are being made. The most important assumption, is for the sake of Comparison to a CD, we need to assume that you do not take out the Cashflow for 10 years but rather keep all the money in the RE Investment's Bank Account. When you first started the Bank Account, you would have deposited the Investment of $30k. Then, after 10 years, you would have sold (or Pretended to sell for purposes of Calculations) in order to know how much money would have been left over. We call that the Sales Proceeds.

Other minor assumptions that are not discussed may not really affect the comparison in any significant way. But I'm open to suggestions.

Anyway, to boil the example above of an Investment of a 2 Family property, we need to create an Equivalent CD Calculation:

You will see in cell K2 that the equivalent of the CoCR example boils down to a 6.43% Return.

By setting up your spreadsheet this way, you can then do all sorts of calculations. Notice that I have an area for Appreciation and Cashflow Growth Rate, both set to zero so we assume none happened in 10 years.

One would say this is a very poor return of only 6.43% per year for 10 straight years.

The reality is that if you compare it to the LAST 10 Years of Treasury Bonds and CDs and probably most people's 401k's, that's probably very good!

In terms of the CoCR, it originally calculates 10.01%. I set up the example purposely so that I can show that if your Criteria is a CoCR of over 10%, this would qualify. HOWEVER, it's really no better than a 6.43% RoR, given the ZERO Appreciation and CF Growth Rate.

Now, let's answer a WHAT IF question... because this is exactly what EXCEL excels AT! The WHAT IF questions!

Let's say we want to make an assumption that the Overall CF will grow. We can hypothesize that rent will increases but only slightly above expenses over the 10 years. Let's say that we want to assume a 1% overall CF growth based on this.

We also think that while Appreciation Rates are around 5% nationally, we didn't invest for Appreciation, but we should get some lower than National Appreciation Rate, let's say only 3%. So, we assume 3% Appreciation and 1% CF Growth. Our spreadsheet example looks like this:

WOW!!! Now we are rocking and rolling!

The calculations are saying that this is the EQUIVALENT of investing in a CD where each and every year that CD returns 11.44% per YEAR for 10 straight Years!!

I personally think that you need to have a Metric that can compare to ANY kind of investing.... not JUST something that compares one REI to another REI.

I'm not sure how other Investors will view this, but I thought that I would put it out here and hopefully help those who are struggling to get a really good understanding of what some of us call FUTURE Value and PRO-FORMA calculations.

While these calculations are not the exact ones that are being used, I think this is a good introduction and can help give the Reader of this Post some understanding of how looking at the Future using projected calculations can help determine what is a good Investment, FOR YOU. Everyone has an idea of what they would like to make in a CD Equivalent. HOWEVER, and this is MOST Important when it comes to FUTURE Calculations... GARBAGE IN MEANS GARBAGE OUT. So I would always be CONSERVATIVE when it comes to making assumptions JUST IN CASE.

The other thing I wanted to give to the Readers of this post is that a proficiency of a Spreadsheet can help a great deal. Every kind of Business, especially financial businesses, RE, etc. use them extensively. The above are really basic future calculations but they demonstrate how you can set up WHAT IF analysis on your projected Investments. I do this for all my RE and Stock/Options trading. It's a worthwhile endeavor to add this to your skill set at a high level.

Anyway, this has been a rather long post. I hope I haven't bored anyone to death!

Thanks for reading.

Investor Llew

[Immanuel Sibero]

@Llewelyn A.

Good Dicussion.

I really don't see a difference in RoR and IRR as you have presented them. IRR is a great metric to evaluate competing investment opportunities. IRR does this by examining the effect of time on the value of cash outlay so timing is everything. In an inflationary environment, the quicker you receive cash the more valuable it is. The more valuable it is the higher the IRR.

I agree with you that CoCR is not a viable metric because it's calculated year by year therefore ignores the time value of money. As shown by your analysis, the effect of time on the cashflow has impaired the IRR/Rate or Return by 3.58% (i.e. 10.01% - 6.43%). Pretty significant!!

Another illustration of the effect of time on cashflow is with respect to the IRR of 6.43% vs IRR of 9.13% that you calculated above. As you have stated, the correct one is the IRR of 6.43%. The "normal" IRR of 9.13% is higher because the timing of the cash outlay has been altered. By listing all the annual cashflow of $3,004 on Column V, the IRR formula assumes that those $3,004 payments are actually made which is contrary to your assumption that no cash payments are made until year 10. In both cases the total cash received is the same, $55,967, but the IRR formula recognizes that it is MORE valuable to receive $55,967 by getting $3,004 every year and $28,930 in year 10 THAN to receive a lump sum of $55,967 all in year 10. It is more valuable because part of the $55,967 is received quicker. The quicker you get it the higher the value, the higher the value the higher the IRR (again assuming inflationary environment).

Also, there are tax implications at the investor level that should be considered. In some scenarios, the implications are insignificant but if you're a 1-percenter they are almost always significant... I'm not a 1-percenter... I only wish :-) Depending on who is in the White House, it's entirely possible the tax implications could tip the scale of IRRs enough to favor one class of investments over another. (i.e. the impact on IRR of the various tax treatment of dividends, capital gain, rental income, preferance deductions, etc).

Changing direction a little bit here... we have covered much about IRR or Rate of Return, and CoCr, but not so much about the other side of the coin which is "Risk", so the rest of my post invites you to go into the subject of Risk. There is a couple of mentions of Risk in this post but not nearly enough coverage given the importance of Risk analysis in selecting an investment opportunity. In fact I think Risk analysis is just as important as Return calculation. They are two sides of the same coin. Part of the reason risk is not talked about as much as Return is because, unlike Return, Risk is hard to quantify and is subjective to each investor.

Both Risk and Return form a framework which I use to make investment decisions. This framework is really just a simple Risk vs Return analysis. Investing in general is like a game, the object of which is to deploy capital into the most profitable investment opportunity. The problem is, capital is a scarce resource. Anytime you deal with scarce resources you are confronted with opportunity costs. So somehow you must come up with an effective way to determine which investment opportunity is the best to deploy your scarce capital into. Risk/Return analysis framework helps you determine the optimal balance of Risk vs Return across various investment opportunities. An optimal balance of Risk vs Return in turn minimizes opportunity costs.

When it comes to risk, there are a few concepts I think about:

INVESTMENT Risk Profile - this is the generally accepted level of risk associated with a certain group/class of investments determined by the markets. Stocks are usually riskier than mutual funds, options are usually riskier than stocks, some real estate investments are riskier than stocks or mutual funds, etc.

INVESTOR Risk Tolerance - this is a subjective, personal posture that an investor takes with respect to the different group/class of investments. Some investors feel more comfortable investing in stocks than in real estate because of prior experience of good results. Some investors got bit hard during the 2007 crash and swore off of stocks no matter how lucrative an opportunity appears to be.

INVESTOR Required Rate of Return - this is the minimum rate of return (i.e. IRR or Yield, etc) that I would accept of a particular investment class before I would invest. This Required Rate of Return can be different for a particular investment or class of investments depending on the Risk Profile of the investment and my personal Risk Tolerance.

For example, using the framework above, based on how comfortable I feel investing in the different classes of investments, and my understanding of the level of risks associated with the different classes of investments, I might decide on the following Required Rate of Returns for the various different class of investments:

- 5% Required Rate of Return for Mutual Funds

- 8% Required Rate of Return for Stocks

- 10% Required Rate of Return (i.e. IRR) for Real Estate

Consider the two scenarios below of how Risk comes into play in selecting an investment opportunity within the Risk/Return framework:

- Let's say I have an opportunity to invest in a stock with expected return of 7.5% (i.e. after researching the stock), and another opportunity in an Single Family rental with 11% CoCR, in this case I would likely invest in the Single Family rental. This is because the Rate of Return of the Single Family is higher than my Required Rate of Return. Similarly, I would not invest in the stock investment opportunity because its Rate of Return is lower than my Required Rate of Return.

- Real Estate investors may further break down real estate investment class. For example, 20% Required Rate of Return for an SFR in a high cap rate area (i.e. higher crime, etc) and 6% Required Rate of Return for a fourplex in a low cap rate area with higher income, professional tenants. In this case, if I was offered an SFR with 19% CoC and a fourplex with 7% CoC, I would invest in the fourplex, despite the much lower Rate of Return. This is because the fourplex return of 7% is higher than my Required Rate of Return for its class of investments. By the same logic, although the SFR return of 19% is much higher than the fourplex return of 7%, I would pass on it because the SFR return is lower than my Required Rate of Return for its class of investments.

This has been a rather long post but it was my intention to give "Risk" equal air time... :-)

BTW if you are using Excel, quite a while back I switched from IRR to XIRR. XIRR does everything IRR does and more... much more. Besides it's more accurate too.

Comments welcome....Immanuel