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Understanding Return On Investment

To identify the cash on cash return of the investment, the cash costs of acquiring the asset are lumped together and are then compared to the cash flow after all the operating expenses and mortgage payments are determined. Over time, as rents increase, the cash on cash return typically improves. If banks are paying higher interest rates on saving, then investors demand better cash on cash returns for their outlay, which usually means that borrowing rates are also high. This ultimately means lower purchase prices. When banks' lending interest rates are very low and they are paying low interest rates on deposits, cap rates will fall; and when cap rates fall, purchase prices go up.

Once we have aggregated all the costs of acquisition and added them to the purchase price, we can simply deduct the loan amount to calculate the money required to close the escrow. This sum represents the cash at work in the investment. Once we know the total cost of acquiring an asset, we can compare that cost to income after all expenses including mortgage payments have been made to determine the before income tax return on investment.

In an earlier example, we had $100,000 of net operating income available to us before we obtained the loan. Let's say that the debt service ratio was 1.2; we are now limited to using $83,333 of the NOI to pay the mortgage and have the other $16,667 to spend as we wish before taxes ($100,000 / 1.2 = $83,333). If we present $250,000 as a down payment and our cost of acquisition was $50,000 for loan points, appraisal, inspections, legal review, etc., we have spent $300,000 of working capital and will get $16,667 back per year - which represents around 5.5 percent cash on cash return before taxes. This is also referred to as the cash flow before taxes.

If the loan is not an interest only loan, the true yield is actually higher: Not all of the mortgage payment is interest, because some of the monthly loan payment goes to reduce the debt, which increases the investor's equity position in the property. This known as the principle pay down, and it increases with each loan payment because the previous month's payment reduced the total debt on the loan. The exception to this is interest only loans, in which the monthly payments do not reduce the principle of the loan. Since the mortgage is usually paid from rents, the principle pay down is a real return on investment for the investor that is realized when they sell or refinance.

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