How to Use Cash-on-Cash Return to Evaluate Real Estate Investments
It’s natural for investors who are new to commercial real estate to be intimidated by the vast array of financial calculations used to evaluate investments. Thankfully, some measures of a property’s value are less complex than others and based on simple math. Take cash-on-cash return, an important and widely-used formula for commercial real estate developers and investors alike.
Cash-on-cash return in real estate transactions calculates the pre-tax “cash” income earned on the “cash” invested in a property. (Hence the need to use “cash” twice in the same measure.) Put simply, it’s the annual return an investor can make in relation to the amount of total cash invested, similar to how a dividend yield on a stock is a measure of cash paid out to investors.
How to calculate cash-on-cash return
Cash-on-cash return is arguably a bit easier to calculate than another important financial ratio used in real-estate: the internal rate of return (IRR). IRR is the rate at which each invested dollar is projected to grow for each period it’s invested. IRR differs from other real estate metrics in that it accounts for the time value of money.
(Read more about mastering IRR in real estate investments.)
Calculating IRR is an important consideration for real estate, which often involves holding periods of five years or more. However, IRR doesn’t allow much insight into the level of annual yields.
Cash-on-cash return provides that insight, and can be calculated with a simple formula:
Cash-on-cash return = Annual pre-tax cash flow / total cash invested
The annual pre-tax cash flow is the Net Operating Income (NOI) of a property, subtracted by capital expenditures and any debt service payments.
Finding the bottom half of the formula is simpler: it’s the cash invested in the project, not including the debt financing. The cash invested is also referred to as the equity in the deal.
Example 1: Find the cash-on-cash return of a real estate investment based on the following assumptions:
- Assume a developer purchases a commercial space for $1,000,000 and takes out an $650,000 mortgage from their bank.
- Assume that after one year of leasing space to various businesses, rental revenue is $115,000.
- Assume that operating expense is $57,500.
- Assume yearly mortgage payments are $26,000.
To calculate the cash-on-cash return for the first year, we must first calculate the annual pretax cash flow, which is equal to $115,000 in total rent, minus $57,500 in operating expenses and $26,000 for mortgage payments. Here, annual pretax cash flow is $31,500.
Then we must find out find the total cash invested, meaning the amount that the company spent on the investment excluding any loans used to finance the deal. In this case, total cash invested is $350,000
Therefore, cash-on-cash return is 9.0%, because $31,500 / $350,000 = .09.
Understanding the limitations of cash-on-cash return
Though cash-on-cash return may help to quantify the annual cash distributions a commercial venture may yield, it’s important for investors to understand that any forward-looking cash-on-cash return estimate or target is not promised money.
Investors should also keep in mind that cash-on-cash return differs from coupons or debt payments, which are regularly scheduled payments that an operator must meet, despite changes in the business plan or market conditions. Investors shouldn’t make the mistake of equating a targeted cash-on-cash return — based on targets of rents and other revenues — to a debt coupon.
The actual cash-on-cash return of an investment may be higher or lower than the targeted number. So while cash-on-cash return analysis is a helpful way to evaluate an investment, it’s not guaranteed.
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