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The relevance of cash-on-cash returns may have escaped your notice as an aspiring real estate investor as you comb through the types of properties to invest in, the kinds of numbers to pay attention to, and the tools to use.
When assessing real estate investments, one of the most important gauges of yearly real estate profitability is the cash-on-cash return. But what do these numbers tell you?
Cash-on-cash return, or CoC, is also known as the cash yield or the equity dividend rate. It appears as a percentage, which is an annual measure of a real estate investor’s earnings on a property compared to the amount the investor initially spent to buy and make it a living space.
In real estate, the CoC is one (if not the most) important metric to understand. It depicts the cash flow of your property by measuring the money coming in after all expenses.
An understanding of this is critical since it helps you choose the best financing for your situation in terms of down payment and loan amount. In short: It helps you assess properties for investment based on their potential profitability.
Cash-on-cash return is one of the most critical metrics to know and understand, especially for new investors. It gives you an understanding of how profitable a real estate investment will be before you buy it and see whether it’s worth your time and money to do so.
As an investor, you may use the cash-on-cash return to evaluate a business plan for a property you’ve been eyeing and the expected cash flow throughout your investment.
If you’re wondering how to calculate cash-on-cash return, consider this example of a $200,000 condo for your investment:
Let’s assume you’re buying it outright with cash without any financing.
After purchasing it, you may rent it out for $3000 a month, but it costs you about $1000 a month to maintain it (HOA, taxes, etc.). This equates to $2,000 per month, or $24,000 in annual pre-tax income (your cash-flow).
Here’s what it would look like on paper:
($3000 rent – $1000 cost) x 12 months = $24,000 pre-tax cash-flow
To get your cash-on-cash return, you’d divide it by the amount you invested:
$24,000 / $200,000 = 0.12 or 12%
12% may seem very lucrative due to the low rent and high maintenance costs of the condo, so, consider this example where you’re financing a property:
You purchase that same $200,000 condo, however, you’re financing it with a mortgage after putting down about $40,000 (20%). Your rent and the up-keep costs per month are the same, but you also have to make a mortgage payment of $1000 every month, leaving you with only $1000 cash every month.
($3000 rent – $1000 cost – $1000 mortgage) x 12 months = $12,000 pre-tax cash-flow
For your cash-on-cash return, you divide it again by the amount you invested:
$12,000 / $40,000 = 0.3 or 30%
As you can see, the percentage changes and is higher despite financing the property and having to pay the mortgage. The second example has a better cash-on-cash return, which means that it’s potentially a better investment opportunity for you.
Key Takeaway: The higher the percentage of cash-on-cash return, the better the investment opportunity.
When it comes to cash-on-cash returns, one of the most often asked questions is, “At what point does it make sense to invest in that property?” After making your calculations, your 8% cash return may prompt you to wonder whether or not this is a worthwhile investment, or if you should just pass on it.
Generally speaking, an 8-12% is a good area to be in to make it worthwhile, however, it also depends on the type of investment. Different investments offer different rates of return. All-cash deals usually have a lower percentage since you don’t have to account for the mortgage payment but it depends on how much money you have to put down to make it worthwhile.
After learning the intricacies of cash-on-cash return, you may wonder how important it is compared to other metrics. After all, it gives a snapshot of the investment property’s potential, while taxes, depreciation, and appreciation aren’t taken into account, nor is the possible profit from selling.
However, it provides an estimate of how much money you may earn in the upcoming year or how much potential that property has to earn. This is compared to how much you need to invest to make it worth it (as seen in the example above between paying the property outright versus only making a downpayment.)
Cash-on-cash return it’s not the only metric you should be looking at or evaluating. New real estate investors may find it difficult to differentiate the nuances of the metrics or why they should even care about the distinctions.
The terms cash-on-cash return and ROI (return on investment) may be thrown your way as you begin to learn more about real estate investment metrics. While both are similar, they differ when real estate debt is involved.
When it comes to commercial real estate, it’s important to keep in mind that the ROI is not the same as the actual cash return because of the greater expenses and the debt involved. The return on cash invested (also known as the down payment) is a more precise way of assessing your investment performance within cash-on-cash return since it takes into account just how much money you’ve previously put in.
Simply put, the ROI gives you the overall profitability (how much total profit or loss you get) over the entire time you own the property whereas cash-on-cash gives you a snapshot of an annual cash flow from the property depending on how much you invested.
The main distinction is that ROI is cumulative and accounts for a property’s debt, but cash-on-cash is not and simply focuses on the money you pay right now.
The internal rate of return (IRR) is a different real estate investment indicator that varies from cash-on-cash return in that it considers cash flow throughout the full holding term rather than just one year. You may wonder why you need both measures, but the one you should focus on will depend on your investment objectives and goals.
However, consider the fact that IRR does not reveal any present cash flow since it takes into account the sale and exit of an asset as well as the cash flow over its life.
When it comes to comparing and contrasting real estate investment metrics, it may be difficult to keep track of all the various parameters. If you’re still trying to figure out which of them to use, the quick answer is all of them.
As each indicator only considers one aspect, skilled real estate investors use all data to get a full picture. For a sense of the investment property’s potential, cash-on-cash is useful but it only represents a snapshot of a single year and not the full period during which you own the property.
Cash-on-cash doesn’t take into account debt, interest rates, any future damages, repairs, appreciation, depreciation, or the final sales price. This is where the other metrics come in.
Which metric you prefer also depends on the type of investment you’re looking into. If you’re looking to settle down and live off of the income generated by a property, you may be more interested in the cash-on-cash return of the potential investment. However, if you’re looking at the long game, both the IRR and the cash-on-cash return are important metrics to assess.
If you’re eying a specific investment property or still unsure how to find the right one, New Western can help you find the best off-market properties in your area that meet your needs. Fill out the form to see if you qualify and one of our agents will reach out to you within 48 hours.
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