An investor came to me not too long ago seeking advice regarding the performance of his portfolio. He figured his portfolio was performing soundly, but wisely decided to seek a CPA’s analysis to help him make investment decisions. My diagnosis: While this investor was sophisticated, he was exclusively analyzing investments by evaluating cash-on-cash return.
There’s nothing wrong with calculating and using cash-on-cash return—the problem arises when it’s your only or primary metric.
First, let’s define what a cash-on-cash return is. In short, it’s a quick way to analyze an investment’s cash flow. Specifically, it produces a percentage that measures the received pre-tax cash flow relative to the amount of money invested.
How to Calculate Cash-on-Cash Return
Calculating cash-on-cash return is simple. We simply divide the received net cash flow for the year by the amount of cash invested.
Not too bad, right? However, it’s the variable—annual pre-tax cash flow and actual cash invested—that can be tricky.
Understanding annual pre-tax cash flow
Calculate your annual pre-tax cash by adding together:
- Gross scheduled rent: The property’s gross rents, multiplied by 12. This reflects the maximum amount of income you can expect to receive.
- Any other income: Think about all of the other earning opportunities the property may present. Will you allow pets and receive pet income and non-refundable deposits? Do you have parking spaces available? Do you get reimbursed for utilities or charge a flat rate regarding such?
- Actual vacancy: If you already own the property and you are wanting to produce the cash-on-cash return to understand your property’s performance, you will want to use actual vacancy here. The actual vacancy should be measured by the numbers of days your property was vacant multiplied the daily rental rate. Otherwise, use potential vacancy—which should always be a conservative number. Multiply your vacancy rate by the gross scheduled rent.
- Operating expenses: This ranges from insurance, taxes, maintenance, HOA and bank fees, property management, and repairs.
- Annual debt service: For the purposes of learning how to calculate cash-on-cash return, this number will be your monthly payment to cover both principal and interest related to your loan. This does not include insurance and taxes.
Calculating actual cash invested
Now let’s calculate the actual cash invested. Combine these numbers:
- Down payment: Simply the amount of money you pay to obtain the property.
- Closing costs: Add up your net closing costs associated with obtaining the property. To do this, add up all of the costs you paid (not including your down payment) and then subtract from that any seller or lender credits given to you.
- Pre-rental improvements and repairs: Pre-rental improvements and repairs includes anything you pay out-of-pocket to fix prior to renting the units out. (This is the part where the cash-on-cash return metric loses some value—it doesn’t do a good job of analyzing returns when you are injecting more cash into the asset after renting out the property.)
When Investors Should Calculate Cash-on-Cash Return
Much of the real estate industry, including investors and agents, use cash-on-cash return. Why? Because of the metric’s simplicity. Here are some times you should calculate this percentage.
1. If you’re determining how much financing to use
This number specifically drills down to the return on the capital invested. It only considers returns that are driven by the property’s net cash flow and doesn’t take asset appreciation into account.
Because cash-on-cash return only compares net cash to the actual cash invested, it’s a great way to assess the effect of leverage so you can measure different levels of financing. Using leverage decreases your cash-on-cash return.
2. If you’re looking for a simple rule of thumb
Many investors are not sophisticated enough to use things like the internal rate of return (IRR) or modified internal rate of return (MIRR). These two metrics can be difficult to learn and understand. Yes, they provide more insight—but also require more work.
It’s easy to understand how to calculate cash-on-cash returns. It’s simply the physical cash you have in hand after 12 months, divided by the physical cash you’ve invested. Because of that simplicity, it’s also a great way to run a “back of the napkin” analysis, and I personally use to quickly screen potential deals. The calculation literally takes 10 minutes or less, and typically gets you within two to five percent of the actual return on equity.
If you’re analyzing hundreds of deals a week, something like this makes a lot of sense.
3. If you’re comparing multiple investments
Cash-on-cash return also allows you to easily compare different investments. You can compare rental property to lending, determine whether you should invest in stocks or bonds, or if you should even start a business. Granted, it doesn’t consider risk factors, but the cash-on-cash return does allow for a universal comparison between different investments.
Why Cash-on-Cash Return Is a Bad Metric
Despite the fact that this metric provides an effective back-of-the-napkin calculation, investors shouldn’t rely on this number.
1. It doesn’t indicate your actual return
Did you really think you were going to get through an entire article—written by a CPA!—without discussing taxes?
Your unique tax situation greatly impacts your actual return on investment. However, some investors argue that your tax situation doesn’t impact the asset’s performance—it is independent of you. They believe taxes should not be taken into account.
However, the tax impact of investment decisions should absolutely be assessed. Your tax situation may not impact the asset’s performance but the asset’s performance directly or indirectly impacts your tax situation, and that affects your returns.
Let’s say your annual pre-tax cash flow is $10,000, and you have invested $100,000. That’s a 10 percent cash-on-cash return. However, if you are in the 25 percent tax bracket, your after-tax cash flow is $7,500—a 7.5 percent actual return.
Further, we have to consider depreciation and amortization. In the example above, if your depreciation and amortization amounts to $8,000 annually, then only $2,000 of cash flow will be taxed. Making our tax liability $500, assuming the same 25 percent rate. Since depreciation and amortization are “phantom” expenses, our after-tax cash flow is $9,500, resulting in a 9.5 percent actual return.
2. It doesn’t account for equity
Yet another wrinkle: This metric doesn’t take into account the equity added from the principal portion of your loan payment. That means it also assumes the entire mortgage payment is an expense. However, the principal portion of your loan payment can’t be expensed for tax purposes.
As you can see, because the cash-on-cash return uses pre-tax numbers and doesn’t account for principal payments, the return suggested should not be trusted.
3. Additional limitations
- Cash-on-cash return doesn’t take appreciation into account. That’s why cash-on-cash return is best used for value investing and not speculation. Depending on how you invest, this could be a good or bad thing.
- It ignores the risk associated with investments.
- This metric doesn’t take opportunity costs into account, which more sophisticated investors will find alarming.
- It also ignores the effect of compounding interest. Cash-on-cash return may make short-term investments look more appealing and make longer-term investments with a lower cash-on-cash return unappealing. But someone interested an investment that compounds, or appreciates, may be better off taking the investment with a (currently) smaller cash-on-cash return.
How Investors Should Use the Cash-on-Cash Return
The conversation I had with my investor friend led him to believe that the cash-on-cash return is a pointless metric. He then became anxious: Had he been missing out on potentially better returns?
“Don’t worry,” I told him. Cash-on-cash return is a great metric—when used appropriately.
First, I wouldn’t suggest using the cash-on-cash return to evaluate the performance of a property you have held for more than 12 months. Only use this number to evaluate or project the property’s first-year performance. After that, the cash-on-cash return begins to lose its value because your denominator—the actual cash invested—will be constantly changing as you pay down the loan and make improvements and repairs. In this situation, I recommend using IRR.
Second, use the cash-on-cash return as a screening tool to compare investments. Many people claim the one and two percent rules are pointless, and I’d agree. But everyone needs a good screening tool, and the cash-on-cash return will allow you to compare investments efficiently and effectively.
Lastly, use other metrics to supplement the information that the cash-on-cash return provides—specifically, the IRR and MIRR. Yes, these two metrics require a bit more work, but they provide more insight into the performance of the property.
So while the cash-on-cash return certainly has weaknesses, it’s a great metric for value investors and serves as a solid screening tool. Using it in tandem with other metrics will provide you with plenty of information to place an offer on a property. And that’s what we’re all about, enabling you to grow your portfolio.
How often do you use the cash-on-cash return formula when evaluating properties? Any questions about this equation?
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