If you’re an investor in rental properties and want to figure out how profitable a real estate deal is, you might have noticed that some metrics don’t quite fit the bill.
As a real estate investor, I have a lot of metrics I use when analyzing properties. Cash on cash return is one I use that showcases a property’s potential return in an easily comparable number.
Here are some other key takeaways to consider when using this formula:
- Cash on cash return is a formula used to give you a quick rundown of the percentage of cash you’ve earned in a month or a year compared to the total cash you’ve put into an investment.
- Cash on cash is shown as a percentage, while actual cash flow is presented as a dollar amount.
What is the Cash on Cash Return Formula
Cash on cash return, also referred to as the “equity dividend rate” or “cash yield” is a simple formula that real estate investors regularly use to measure their assets.
It is used to compare a real estate asset’s current or potential profitability. In this case, a rental property.
It involves measuring the amount of annual cash flow a property is generating divided by the total cash investment. The result is then multiplied by a hundred so that the return rate is shown as a percentage.
In simpler terms, cash on cash return tells you how much investment you will earn back each year. The higher the return figure, the more worthwhile the property investment.
3 Reasons Why You Need to Know the Cash on Cash Return Rate
Evaluating the potential profitability of a property is the reason why cash on cash returns are highly valued in the real estate investing world.
This formula can be a great way to determine how an investment will perform and ultimately help you determine whether it’s worth it to plop down cash money in a real estate investment property:
- Evaluating Investments – The simplicity of the cash on cash return helps you make consistent investment decisions. It allows you to compare different investment opportunities and assess their potential returns.
Knowing the expected return on your investment, you can determine whether a particular rental property aligns with your goals and risk tolerance. Plus, it also helps you select the most attractive investment opportunity.
For example, if you evaluate a property and need to increase its expected monthly rent in the next 2-3 years, it’s a good idea to recalculate your actual cash return to how it will perform.
- Risk Assessment – Cash on cash returns can help you test the waters of a rental property. It helps you gauge the risk associated with a real estate investment.
A higher cash on cash return often indicates a more favorable risk-return profile, while a lower one may suggest greater risk or lower potential returns.
- Cash Flow Management: Cash on Cash Return provides valuable information for managing your cash flow. It enables you to estimate your expected annual net income relative to your initial cash investment.
This is essential for budgeting, planning expenses, and ensuring your investment aligns with your financial objectives.
How to compute your cash on cash return formula
Here’s the formula to compute your cash on cash return rate:
Pretty straightforward, right? Keep in mind, it’s important to note that this return is commonly expressed after factoring in debt service (which covers mortgage or loan payments) and can include or exclude principal debt payments.
Let’s look at the formulas for calculating the cash on cash return for a real estate investment.
Annual pre-tax cash flow (after debt service):
This formula looks at your profit after paying all your expenses, like taxes, repairs, and renovations. This is the money you have left over in your pocket. It doesn’t consider the money you’re paying back on any loans you might have taken to buy the property. Here’s the formula:
Annual Pre-Tax Cash Flow (After Debt Service) = Annual Rental Income – Annual Operating Expenses – Annual Debt Service
For example, your annual rental income (minus tax) is $10,000. Divide that by your total cash invested, which is $100,000. You’ll have a 10% cash on cash return rate.
Key Considerations For Successfully Calculating Your Cash On Cash Return
Calculating your cash on cash return can only become a little complex if you’re unfamiliar with your annual net cash flow. Your annual cash flow tells you how much rental income you’ll have after covering all your expenses.
I find that listing down your monthly rental income and expenses is the most efficient way to calculate your annual cash flow. Here are the common expenses that can affect your calculations:
- Annual mortgage payments
- Property taxes and insurance
- Utilities (electricity, water, gas)
- Maintenance costs
- Property management costs
- Homeowner’s Association (HOA) fees (if applicable)
What is a good cash on cash return rate?
To be honest, there’s no good return rate that’s set in stone. It largely depends on what your investment objectives are.
For beginner investors, a good cash on cash return rate should be between 5-7% and then increase their metrics as they gain experience in “eyeing” a rental property.
However, most real estate investors agree that a healthy cash on cash return rate is between 8-12%. I also know some real estate investors indicate that a good return rate doesn’t go under 20%.
If you invest in a growing market, like a booming vacation tourist spot, you may rake in lower returns, but that doesn’t mean you’re investing in a bad deal. Keep in mind that your return rate is largely influenced by how much you spend on your own dime and how solid is your cash flow structured.
Remember, cash on cash return is only one of several formulas you can use to evaluate rental properties. That’s why investors use several different formulas to gauge how profitable is an investment property.
I recommend always keeping this formula in your real estate investing metrics as you grow your portfolio. In the meantime, here are some alternatives to the cash on cash return formula:
Alternatives to Cash On Cash Return
Now that we have covered the definition and how to calculate cash on cash return, let’s take a look at other real estate metrics investors use to evaluate the performance of their assets:
Net Operating Income (NOI)
Net operating income, or NOI, is calculated by subtracting all property operating expenses from the total income a property generates. Operating expenses can include a property’s landscaping, utilities, and maintenance costs.
Cash On Cash Return Vs. NOI
The main difference is that cash on cash return rates factor debt services into the equation, while NOI excludes them.
Since NOI is a standardized metric, it paints an objective picture of a property’s financial performance by accounting for all revenues and expenses, allowing for better comparisons between different properties.
The capitalization rate, often called the cap rate, is a metric used to evaluate and compare the potential returns of investment properties in the same market. The cap rate is calculated using the following formula:
For example, if a property’s market price is $2,000,000, and its Net Operating Income (NOI) before accounting for debt service is $120,000, the cap rate would be 6%.
You can also rearrange the equation to use the cap rate formula for determining the market value of a property based on the NOI and cap rates of similar properties. This is useful for estimating a property’s value in a given market.
Cash On Cash Return Vs. Cap Rate
The capitalization rate formula offers an alternative way to assess the potential profitability of an investment by using different metrics than cash on cash returns.
The cap rate is determined by dividing the property’s net operating income by its sales price. This number can then be converted into a percentage and used to compare properties within a similar area.
In contrast, cash on cash returns provide a more detailed perspective on the potential profits, while cap rate aids investors in making decisions between potential investments in the same property.
Internal Rate of Return (IRR)
Internal rate of return, or IRR, is used to evaluate the potential profitability and attractiveness of an investment property. It represents the annualized return rate to an investor based on all the money generated by the property during the entire holding period.
IRR is a measure where you look at things like… “can you raise rent?” If you add a hot tub to your property, can you charge more? So you take those factors and make a projection– an estimate.
In simpler terms, the IRR is a measure of how good an investment is, and if you have to wait a long time to get your money back, the IRR might not be as high– which may be a bad investment.
Cash On Cash Return Vs. IRR
Both metrics have their own advantages and applications in investment analysis.
IRR is used for assessing the overall long-term profitability of an investment by determining the potential total cash flow, initial investment costs, and the holding period.
Cash on cash return is particularly useful for understanding the short-term cash return and liquidity of an investment by focusing on profitability to the initial cash investment. Plus, it’s easier to comprehend and use than IRR.
Return On Investment (ROI)
Return on investment, or ROI, measures the income from the property (after expenses)/cost of the investment. The ROI formula is:
Cash On Cash Vs. ROI
Investors sometimes like to mix up two terms these two terms, but they are different.
Here’s a simple comparison table:
|Aspect||Cash on Cash Return Formula||ROI Formula|
|Definition||It can be used for any type of investment including stocks, bonds, and real estate.||Measures the total return of an investment relative to the cost of the investment.|
|Formula||Cash on Cash Return = (Annual Pre-Tax Cash Flow / Total Cash Invested) * 100%||ROI = (Current Value of Investment – Cost of Investment) / Cost of Investment * 100%|
|Usage||Used specifically in real estate investments where there is a mortgage involved.||It can be used for any type of investment, including stocks, bonds, and real estate.|
|Consideration||Only considers the cash flow before taxes and the initial cash investment.||It can be used for any time period.|
|Time Frame||Typically used for annual analysis.||Can be used for any time period.|
My Experience With The Cash On Cash Return Formula
If you’ve just learned about the cash on cash return formula, you’ll likely find it quite useful for your real estate projects.
Not only is it handy for quickly gauging returns based on your cash flow, but also for assessing the viability of potential deals and deciding how much cash you’ll shell out as a down payment.
However, remember that it shouldn’t be your only tool! Experienced investors like myself, rely on a combination of metrics– including this formula, to thoroughly evaluate real estate deals.
So, the next time you come across a promising investment property, give the cash on cash return metric a try, and you’ll see just how easy it is to use.
What is a good cash on cash return on Airbnb?
Since Airbnb units are largely short-term rental properties, a good cash on cash return rate depends on the local market conditions, property expenses, and the investor’s financial goals and risk tolerance, which puts their desired rate between 8-12%.
What is a reasonable cash on cash return for a rental property?
It depends on the market, for beginner real estate investors, your projected cash on cash return rate should be 7-10%.
Why is tax excluded from the calculation?
Tax is excluded from the cash on cash return formula because an investor’s tax rate largely depends on their income, which can be a wild card when analyzing rental properties. Excluding tax from the formula makes it easier to compare different outcomes across your investments.