This article explains the benefits of cash-on-cash return as a metric to understand the cash flow of a real estate investment opportunity. One of the benefits of investing in real estate compared to other investments, such as stocks, is that real estate cash flows in addition to any potential appreciation. Rental income, after deducting expenses associated with holding the property, is profit that hits the owner’s bottom line.
If you are a fractional property owner or a limited partner (LP) in a real estate deal, that profit gets distributed to you. One of the ways of gauging how much cash flow the property will generate based on the cash you put in is measured with the cash-on-cash-return metric.
What is Cash-on-Cash Return and How is it Calculated
Cash-on-cash return is a metric that measures the cash flow generated by a property relative to the cash invested. It is calculated by dividing the annual income generated by a property after deducting all of the operating expenses, including debt service (such as mortgage payments) and taxes, by the cash invested in the property.
If, for example, a property generates $10,000 in annual cash flow after all expenses on the property, the cash-on-cash return would be 10% — his means that the investor is earning a 10% return on the cash invested in the property. So, in this case, cash-on-cash return: $10,000 / $100,000 (cash invested) = 10%
Typically, the cash-on-cash return is calculated annually, so in the scenario above, that 10% cash-on-cash return is based on the $10,000 earned in a 12-month period, and the 10% would be an annual cash-on-cash return. One of the key benefits of owning real estate is cash flow, so this metric is crucial for any real estate investor.
Another advantage of using the cash-on-cash return metric is that it is easy to understand and calculate. It provides a clear and straightforward way to evaluate the cash flow generated by a property relative to the cash invested. Additionally, it helps investors quickly identify properties that yield the highest cash flow relative to the cash invested.
Comparing Cash-on-Cash Return to Other Metrics in Real Estate Investing
It is important to note that unlike internal rate of return (IRR) and equity multiple that measure the overall return on investment (ROI) of a property and are more sensitive to changes in property value, cash-on-cash return is calculated independently of any changes in property value. For example, a property with a high IRR or equity multiple may be considered a good investment, but if the property value decreases, the overall ROI will also decrease, even if the cash flow generated by the property remains the same. Similarly, IRR and equity multiple may initially be high because the sponsor or owner predicts the property will appreciate over the holding period even if the cash flow is relatively low.
How to effectively analyze Real Estate Investment Opportunities
Given that cash-on-cash return only reflects the cash flow generated by the property and does not take into account the property’s appreciation over time, other metrics are more suitable when evaluating the overall ROI of a property. Also, consider that expenses on a property can fluctuate, and rent can also decrease overall, affecting the cash-on-cash return.
In conclusion, cash-on-cash return is a valuable metric for evaluating the cash flow generated by a property relative to the cash invested. It is easy to understand and calculate and less affected by property value changes compared to other metrics such as IRR and equity multiple. However, it has its limitations and should be used with other metrics such as IRR, equity multiple, and cap rate to evaluate the overall ROI of a property. While investing in real estate can provide good returns and are usually cash-flowing assets, it’s essential to use multiple metrics and have a solid understanding of the risks involved before investing.