Cash on Cash Return is the percentage of annual income your cash investment earns on a real estate investment after debt service. When it comes to investing, the ratio of the cash-on-cash return is defined as the before tax annual cash flow or net operating income divided by the whole amount of money invested, put as a percentage.
Don’t Fall Into the Cash on Cash Return Trap
You might as well face it. When you are investing in income producing real estate, what excites you the most is the cash on cash return – which is the percentage of how much you will earn on the cash you are investing. Realtors certainly know how to play into this. After all, they are in the sales business. And what is going to motivate you the most is when they tell you something like “the cash on cash return on this property is beyond amazing. You only have to put $200,000 down and your money will earn 16% a year." Yes, that does get your attention. This is exactly what was told to a client of mine who was in love with an eight-unit apartment complex in Gresham, Oregon. He told me “Look at this offering memorandum I wouldn’t want to live in one of these units, but this is such a cash cow!” And there is an upside too – the rents are at least a hundred dollars below market. The photos showed a dated, but very well-maintained property with mature landscaping. Who was to know that these photos were taken years ago.
As real estate investors, we love to search for the best deal – it is inherent for us to search through dozens of property offerings to find the one that everyone else has missed. For those of us who are motivated by earning the most on the cash invested, a realtor offering an unrealistically high cash on cash return might be able to reel us in. The first thing I noticed about the expenses presented in the memorandum was that repairs and maintenance were exceptionally low at only 4% of the gross rental income. Based on the property being 44 years old this could mean that the seller was not maintaining the property. Of course, if you never replace or fix anything, the net income will be a lot higher. When I brought this up to my client he said, “but look how nice the property looks." So when we drove out to look at it, and it was obvious that the photos had been taken many years ago we both felt that sinking feeling in our stomachs. There was a slight curvature to the roof that suggested major roof repair, exterior painting had been recently quickly done without scrapping off the old paint, and the parking lot needed to be resurfaced. Also, the memorandum had an 80% loan at a rate that didn’t seem believable to me as a 20 year veteran as a commercial mortgage broker. To add more injury the actual income and expenses presented showed that the property would only cash flow a 68% loan, not the 80% the realtor was selling. And to add more insult to injury, the realtor did not include closing costs in the cash on cash return calculation. So on the back of a napkin we added in the additional down payment of $48,000, increased repairs and maintenance annually to $8,000 ($1,000 per unit based on the condition of the property) included the closing costs of about $12,000 and the cash on cash return fell from 16% to 5.5%. And this did not include the roof and driveway repair. My client declined purchasing this property and falling into the cash on cash return trap.
How is Cash on Cash Return Calculated?
Cash on cash return is simply the annual net operating income (gross rental income minus expenses) minus annual loan payments (principal and interest) divided by the amount of cash (including closing costs) you are investing in the property.
Let’s say that an investor buys a $2,400,000 multifamily property that is in great shape and does not need any improvements. The investor puts $600,000 down including closing costs. Annual cash flow from rental units minus expenses is $180,000 which is the Net Operating Income (NOI). There is a $1,800,000 mortgage. The annual principal and interest payments of $115,953 have to be subtracted from the net operating income.
To compute the Cash on Cash Return:
Annual Net Operating Income: $180,000
Less Annual Mortgage Payments: – 115,953
Adjusted Net Income: $64,047
Now take the Adjusted Net Income and divide it by the cash invested:
$64,047/$600,000 = 10.67% Cash on Cash Return
$4,000 X 12 = $48,000. $120,000 - $48,000 = $72,000
$72,000/$600,000 = 0.12 X 100 = 12 percent.
What Is A Good Cash on Cash Return?
Obviously, buying a property in good condition, with good rents at a great price will produce the best cash on cash return. Contrarily, buying a property that needs a lot of work with lower than market rents at a low cap rate will produce a low cash on cash return. The best way to look at this is to think about what you would expect to earn in an average risk stock market investment. I think we can agree that 6% to 8% would be good. Taking into consideration that investing in income producing real estate takes a lot more work than just receiving earnings from stock, the 12% return on cash invested in the example above seems excellent. But in a seller’s market with low cap rates and high sales prices, getting a 9% to 10% cash on cash return on your investment is very good.
Four Ways to Maximize Cash on Cash Return
- Finding a property that is being sold at a good price
- Calculating accurately the amout of repairs or rehab the property will need
- Finding the best financing – highest leverage with the lowest payments
- Being able to raise rents substantially during the first year of ownership
It’s not easy in this market to find a good deal on an investment property. But putting time into this will greatly increase your cash on cash return. Loopnet is a great place to search for properties and compare prices: loopnet.com
Often when buying an investment property the investor’s initial assessment of the property is better than what is actual. Therefore, it is essential to have a property condition report done to determine the actual condition of the property. Once purchased, if you find out that the property needs a lot more work then you thought, this will obviously lower your cash on cash return.
The quality of the financing you can obtain is another important factor. Usually obtaining higher leverage (less down) will increase your cash on cash return. Interest rate and amortization are a factor as well. At Apartment Loan Store, we also provide interest only commercial mortgages to help our clients obtain the best cash on cash return. An interest only mortgage at a low rate will greatly increase your cash on cash return.
Finding a property that has under market rents that can be raised by 5% or more during the first year of ownership will greatly increase your cash on cash return as well.
It is important to keep in mind that some investors use cash-on-cash return to see if a particular property is undervalued. But it is very important for these investors to accurately know what they are buying – the quality of the neighborhood, and the condition of the property. Buying a D quality property in a bad neighborhood and in poor condition will of course produce the highest cash on cash return, but also produce the greatest headache.
However, if you are looking at an apartment complex and your evaluation for cash-on-cash return shows quick equity, it is highly recommended that you do an in-depth analysis of not only cash-on-cash return, but also the offering memorandum to make sure that everything presented is accurate.
There are so many factors that can mislead investors into thinking they are going to have instant equity and a fabulous cash on cash return. For example, it is quite common for offering memorandums to exaggerate the profitability of properties, and to have wording that is misleading. And again, regarding the cash-on-cash return calculation, it is limited in its accuracy – so you need to do a much deeper cash flow analysis and property condition analysis.
Some limitations of cash-on-cash return
1. The cash-on-cash return does not take in account the tax situation of the individual investor. It’s calculated on before tax cash flow as it relates to the cash amount invested. Each investor has a different tax situation, so cash-on-cash return can not include the investor’s tax as part of the calculation.
However, the investor’s tax situation is key because it could influence whether or not a property is a profitable investment.
An after tax cash-on-cash return calculation could possibly be done. But, your adjustable taxable income must be figured accurately to figure out the amount of tax payment being saved through losses including depreciation.
2. Cash-on-cash return does not include appreciation or depreciation. So for example, if some cash is return of capital, you will falsely get a higher return. This is because return of capital doesn’t happen to be income.
3. Other risks connected to the subject property are not taken into account, such as are there problems with rent collections. Take a look at not just physical occupancy but economic occupancy. Just because a tenant is listed on the rent roll does not mean they are paying rent.
Compare monthly gross rental income on the P and L’s to the rent roll to do this analysis.
4. Basically the cash-on-cash return is a calculation of simple interest. The calculation ignores how compound interest would affect the result. For investors this implies that if your investment has a lesser nominal rate of compound interest, it could be better, in the long run than an investment that has a bigger cash-on-cash return.
By Terry Painter/President Apartment Loan Store and Business Loan Store