Cash on Cash Return

The cash-on-cash return of an investment property is a measurement of its cash flow divided by the amount of capital you initially invested. This is usually calculated on the before tax cash flow, and is typically expressed as a percentage.

Cash-on-cash returns are most accurate when calculated on the first year's expected cash flow. It becomes less accurate and less useful when used on future years because this calculation does not take into account the time-value of money (the principle that your money today will be worth less in the future).  However, you must also take into account that inflationary decrease in money will be offset with slighly rent increases in your rental property over time.

Therefore, the cash-on-cash return is not a powerful measurement, but it makes for an easy and popular "quick check" on a property to compare it against other investments. For example, a property might give you a 7% cash return in the first year versus a 2.5% return on a bank CD.

The cash-on-cash return is calculated by dividing the annual cash flow by your cash invested:

     Annual Cash Flow / Cash Invested  =  Cash-on-Cash Return

Let's make sure we understand the two parts of this equation:

1.  The first-year cash flow (or annual cash flow) is the amount of money we expect the property to generate during its first year of operation. Again, this is usually cash flow before tax. This money is not net-income, but the income after all debt service has been made, i.e: mortgage payments and fixed expenses, what is left over as "cash-in-hand". 
   
   
2. The initial investment (or cash invested) is generally the down payment. However, some investors include their closing costs such as loan points, escrow and title fees, appraisal, and inspection costs. The sum of which is also referred to as the cost of acquisition.

Let's look at an example. Let's say that your property's annual cash flow (before tax) is $8,400. And let's say that you made a 20% down payment equal to $84,000 to purchase the property. In this example your cash-on-cash return would be 10%.

     $8,400 / $84,000  =  10%

Although the cash-on-cash return is quick and easy to calculate, it's not the best way to measure the performance and quality of a real estate investment. Future articles will introduce you to better ways to evaluate your real estate investments.

Other terms to understand are GRM, or Gross rent Multiplier, and Capitalization Rate. 

Simply stated, the GRM is the gross rents, before any debt service, or fixed operating expenses as a multiple of price. For example, if a 6 unit building has gross annual rents of $74,000 per year and has a price tag of $740,000  the property has a Gross Rent Multiplier of 10:1.  On the other hand, if a property has a price tag of $425,000 and has gross rents of $57,000, it has a gross rent multiplier of 8:1.  In the case of GRM, smaller is better. In the case of Cash on Cash Return, or in the cap rate, bigger is better.

Cap Rate is simply the Net-Income, before mortgage payments, but after subtracting fixed operating expenses, devided by purchase price.  It is a way of measuring how much income potential a property produces relative to its price.  So for instance, two identical properties,with a price of $525,000 can each have a GRM of 10:1, meaning, each property has gross rents of $52,500 per year.  Each property requires 20% down, or that is, $105,000.00.  However, one property, because it has tenant paid heat, instead of landlord paid heat, has a cap rate of 8.4% but the other has a cap rate of 6.3%.  In this example, they both have similiar price tags, similar GRM, but different Cap Rates and therefore, different cash on cash rates of return. Obviously the property with the 8.4% cap rate has identical mortgage debt service, but lower fixed operating expenses, and thus produces more positive cash flow.

In sum, you want a property with a low GRM, and a high cap rate.  This in turn, makes for a good cash-on-cash return. 

So terms like GRM, Cap Rate, and Cash-on-Cash return are important words to understand when looking at commercial real estate for investment.