An investor came to me not too long ago seeking advice regarding the performance of his portfolio. He figured his portfolio was performing soundly, but wisely decided to seek a CPA’s analysis to help him make investment decisions.
While this investor was sophisticated, he was analyzing his returns on his current properties and returns on potential deals using the cash-on-cash metric. There is, of course, nothing wrong with using the cash-on-cash return metric; the problem arises when it’s the only metric, or the primary metric, used in making investment decisions.
This article is going to go over the conversation I had with this investor so that you may benefit from it. I’ll discuss how to calculate the cash-on-cash return, the good qualities, the bad qualities, and how investors can use the metric to help aid investment decisions.
Before we get started, let’s first define what the cash-on-cash return is. The cash-on-cash return is a quick way to analyze an investment’s cash flow. Specifically, it will produce a percentage rate that measures the received pre-tax cash flow relative to the amount of money invested to acquire the asset.
How to Calculate Cash-on-Cash Return
Calculating cash-on-cash return is simple. We simply divide the received net cash flow for the year by the amount of cash invested.
The overarching equation isn’t bad at all. It’s the variable, such as annual pre-tax cash flow and actual cash invested, that can become somewhat tricky.
Annual Pre-Tax Cash Flow
The formula to calculate your annual pre-tax cash flow is as follows:
Let’s break each of these variables down.
Gross Scheduled Rent
When you are evaluating a property’s performance, “gross scheduled rent” will be the property’s gross rents, multiplied by 12. This reflects the maximum amount of income you can expect to receive from a property.
Think about all of the other earning opportunities the property may present. Will you allow pets and receive pet income and non-refundable deposits? Do you have parking spaces available? Do you get reimbursed for utilities or charge a flat rate regarding such? All of this miscellaneous income will be included in “other income” for our cash-on-cash return analysis.
If you already own the property and you are wanting to produce the cash-on-cash return to understand your property’s performance, you will want to use actual vacancy here. The actual vacancy should be measured by the numbers of days your property was vacant multiplied the daily rental rate. Essentially, this is the rental income you lost, on a daily basis, due to a tenant not being in place.
If instead you are analyzing a property’s potential performance, you will want to use potential vacancy. This should always be a conservative number. You can guesstimate potential vacancy by calling up property management firms in the area or asking a real estate agent to run an analysis on how long a unit stayed on market. You will be able to generate a percentage rate of vacant days compared to the entire year. Whatever that rate is, I’d go ahead and add 2%. This will help create a small buffer as you learn the ins and outs of the market and what tenants expect a rental unit to look like.
For example, if a unit sat unrented on the market for 45 days, then the vacancy rate is 12.33% (45/365). Go ahead and round up to 14% for your projected vacancy rate.
Now we’ll take that vacancy rate and multiply it by the gross scheduled rent. The result will be the amount of rental income you expect to not collect due to the unit not being rented. This can also be considered your opportunity cost.
Operating expenses will range from insurance, taxes, maintenance, HOA and bank fees, property management, and repairs. Operating expenses do not include debt service (principal and interest), nor do they include depreciation or amortization.
There are plenty of articles on Szikov providing insight on how to estimate operating expenses. I recommend checking them out if you don’t know how to already.
Annual Debt Service
For the purposes of learning how to calculate cash-on-cash return, this number will be your monthly payment to cover both principal and interest related to your loan. This does not include insurance and taxes.
Actual Cash Invested
OK, now that we know how to calculate the annual pre-tax cash flow, let’s figure out how to calculate the actual cash invested.
Let’s also break each of these variables down.
This has nothing tricky to it. It will simply be the amount of money you pay as required by your lender to obtain the property. Very simple.
Closing costs are also somewhat simple. Basically, you will add up your net closing costs associated with obtaining the property. To do this, add up all of the costs you paid (not including your down payment) and then subtract from that any seller or lender credits given to you.
Remember, we really only want to use cash-on-cash return to analyze a return based on the cash we have actually invested into the property. I suggest only using pre-rental improvements and repairs because I think the cash-on-cash return should really only be utilized in the first year of ownership. More on that later.
Pre-rental improvements/repairs will include anything you pay out-of-pocket to fix prior to renting the units out. This is the part where the cash-on-cash return loses some of its value, as it doesn’t do a good job of analyzing returns when you are injecting more cash into the asset after renting out the property.
So there you have it. I explained how to calculate cash-on-cash return in just 800 words. Is your head spinning yet? No? Good. Time to move on to the theory and application of using cash-on-cash returns.
Why the Cash-on-Cash Return is a Good Metric
The cash-on-cash return is a great metric and is widely used throughout the real estate industry both investors and real estate agents. The primary reason for this is due to the metric’s simplicity in calculating the percentage return.
The cash-on-cash return specifically drills down in the return on the capital invested. It does so by only considering returns that are driven by the property’s net cash flow. It is an essential part to value investing because it does not take into account asset appreciation.
Because the cash-on-cash return is only looking at the net cash flow and comparing it to the actual amount of cash invested, it’s a great indicator for the effect of leverage. Using leverage will decrease your cash-on-cash return, which makes the metric a good way to measure different levels of financing.
Many investors are not sophisticated enough to use things like the Internal Rate of Return (IRR) or Modified Internal Rate of Return (MIRR). These two metrics can be quite encumbering to learn and fully understand. And even though they provide much more insight, they also require much more work.
On the other hand, it’s easy for everyone to understand how cash-on-cash returns are calculated. It’s simply the physical cash you have in hand after 12 months, divided by the physical cash you’ve invested. Since investors can easily understand the calculation, that’s what sellers and agents use when discussing potential returns on the properties they are marketing.
Because of its simplicity, it’s also a great way to run a “back of the napkin” analysis. I personally use it as a screening tool when evaluating potential deals. The calculation can be run in literally 10 minutes or less and will likely get you within 2-5% of the actual return on equity in most situations. If you’re analyzing hundreds of deals a week, something like the cash-on-cash return makes a lot of sense.
The cash-on-cash return also allows you to easily compare different investments. You can compare rental property to lending, investing in stocks or bonds, and even starting a business. Granted, risk factors are not considered (which is a limitation we’ll discuss in a minute), but the cash-on-cash return does allow for a universal comparison between different investments.
Why the Cash-on-Cash Return is a Bad Metric
The number one limitation, in my opinion, to the cash-on-cash return is that it doesn’t indicate your actual return. There are two reasons for this: (1) taxes and (2) loan pay down.
Did you really think you were going to get through an entire article, written by a CPA, without discussing taxes?
Your tax situation is unique to you and will greatly impact your actual return on investment. Many investors argue that your tax situation doesn’t impact the asset’s performance — it is independent of you. Therefore, taxes should not be taken into account.
However, the tax impact of investment decisions should absolutely be assessed. While your tax situation may not impact the asset’s performance, the asset’s performance will directly or indirectly impact your tax situation. The effect can greatly increase or decrease your actual returns.
For instance, let’s say your annual pre-tax cash flow is $10,000, resulting in a 10% cash-on-cash return (assuming you invested $100,000). If you are in the 25% tax bracket, your after-tax cash flow is $7,500 resulting in a 7.5% actual return.
Further, we have to take depreciation and amortization into account. In the example above, if your depreciation and amortization amounts to $8,000 annually, then only $2,000 of cash flow is remaining to be taxed. At the same 25% rate, our tax liability is $500. Since depreciation and amortization are “phantom” expenses, our after-tax cash flow is $9,500 ($10,000-$500), resulting in a 9.5% actual return.
But then there’s another wrinkle to all of this. The cash-on-cash return doesn’t take into account the equity added from the principal portion of your loan payment. It also assumes the entire mortgage payment is an expense, which we know the principal portion of your loan payment cannot be expensed for tax purposes.
As you can see, because the cash-on-cash return uses pre-tax numbers and doesn’t account for principal payments, the return suggested should not be trusted.
Another limitation is the simple fact that the cash-on-cash return doesn’t take into account appreciation. As I stated a bit earlier, this supports the view that the cash-on-cash return is used for value investing and not used for speculation. Depending on how you invest, this could be a good or bad thing.
The cash-on cash-return ignores the risk associated with investments. It doesn’t take into account opportunity costs, which more sophisticated investors will find alarming.
It also ignores the effect of compounding interest. The problem here is that the cash-on-cash return may make short-term investments look more appealing while making longer-term investments with a lower cash-on-cash return unappealing. If the investor were to invest in an investment that compounds (or appreciates), then the investor may be better off taking the currently smaller cash-on-cash return in the long-run.
How You Should Use the Cash-on-Cash Return
Coming full circle, the conversation I was having with this investor led him to believe that the cash-on-cash return is a pointless metric. He then became anxious that he had been missing out on potentially better returns for the past several years.
But I told him not to worry because the cash-on-cash return is a great metric if used appropriately.
First, I wouldn’t suggest using the cash-on-cash return to evaluate the performance of a property you have held for more than 12 months. It should really only be utilized to evaluate the first year’s performance or project a property’s first year performance. After that, the cash-on-cash return begins to lose its value. The reason being that your denominator (actual cash invested) will be constantly changing as you pay down the loan and make improvements and repairs to the property. A better metric to use in this case is the IRR.
Second, use the cash-on-cash return as a screening tool to compare other investments. Many people claim the 1% and 2% rules are pointless, and I’d agree. But everyone needs a good screening tool, and the cash-on-cash return will allow you to compare investments efficiently and effectively.
Lastly, use other metrics to supplement the information that the cash-on-cash return provides you. Specifically, the IRR and the MIRR. Again, these two metrics require a bit more work but provide you with much more insight into the performance of the property.
So while the cash-on-cash return certainly has weaknesses, it’s a great metric for value investors and serves as a solid screening tool. Using it in tandem with other metrics will provide you with plenty of information to place an offer on a property. And that’s what we’re all about — enabling you to grow your portfolio.
How often do you use the cash-on-cash return formula when evaluating properties? Any questions about this equation?
Leave your comments below!