Most real estate investors are fascinated by the idea of real estate investments as an ATM machine for passive income. You buy a property, rent it out, and if the income exceeds the expenses, you have created positive cash flow. Do that enough times, and you can be financially free.
This line of thinking leads to a singular focus on cash-on-cash returns. For instance, if you invested $40,000 in a property and it produced $3,600 in positive cash flow after expenses, your cash-on-cash return is 9%. Follow this thought experiment even further, and you will find that this focus on cash-on-cash returns leads to arbitrary return anchors.
For instance, you might find an investor says something like, “I don’t buy a property unless it yields a X% cash-on-cash return.” In other words, an incomplete investment measure just became a property selection filter.
Do Cash-on-Cash Returns Really Drive Real Estate Investment Returns?
So what’s wrong with that—don’t we need a target to filter out the noise? How would we make decisions if returns don’t matter and everything goes?
The truth is returns do matter. But the important question is: do cash-on-cash returns really drive real estate investment returns? If you were to look at the big investment return picture, what role do cash-on-cash returns play versus other forms of returns?
Before we look at a case study that presents the big picture in easy-to-understand terms, we have to go over the four different types of returns that real estate investments provide and the investment measure that encompasses them all.
Real estate investments provide returns to investors in four different ways:
- Cash Flow
- Debt Paydown
We have already covered cash flow and the measure we use to calculate it. Debt paydown is the amount of principal paid to the investor’s mortgage every month. The tenant pays rent, which covers the investor’s mortgage payment, a portion of which systematically reduces the liabilities and increases the net worth of the investor.
Appreciation & Depreciation
Appreciation is the increase in value that the property experiences during the investor’s ownership period. This increase in value increases the investor’s net worth and can only be unlocked by selling the property or borrowing against it. Depreciation is a paper expense that the investor can deduct against his rental income which results in either:
- A lower effective tax rate,
- No taxes on the income, or
- A paper loss that results in tax benefits to the investor.
The cash-on-cash return is a good measure of what return the investor is getting from the positive cash flow on the property. In addition, it’s an easy-to-calculate number, so it makes decisions simpler. But it’s an incomplete measure, because it does not account well for any of the other forms of return the investor receives from the property.
The Better Way to Measure Forms of Return
A better measure that accounts for all the forms of return mentioned above is the internal rate of return (IRR). IRR looks at a real estate investment as a stream of cash flows over time and calculates the total return for that timeframe. As such, it encompasses all the forms of return into one figure and gives you a more accurate picture.
Let’s look at a basic case study example. Suppose you have a property that you purchase for $100,000 with 20 percent down that produces $2,000 per year in income after all expenses. Let’s assume you keep this property for 8 years and sell it at the market value which has appreciated at 4 percent per year every year you hold it.
First, let’s calculate the cash-on-cash return. You invested $20,000 in this property (cash in), and it produces $2,000 per year in cash flow (cash out) for a cash-on-cash return of 10 percent.
Now let’s look at the internal rate of return calculation.
|YR 0||YR 1||YR 2||YR 3||YR 4||YR 5||YR 6||YR 7||YR 8|
IRR = 23.3%
That table may look complicated, but it’s actually very simple. When you first purchase the property, you invest $20,000 so that cash flow is negative. In Years 1-7, the property produces positive cash flow of $2,000 per year. In the last year, the calculation assumes you got the $2,000 cash flow for the year and you sold the property, receiving back your investment and any property appreciation and debt paydown that has happened in that period of time.
The total return (internal rate of return) is 23.3 percent. The cash-on-cash return is less than half (43 percent) of the total return—and yet most investors use that measure to make property decisions.
Why Cash-on-Cash Return Is Inadequate on Its Own
But you might be asking, “If the cash-on-cash return is high enough, doesn’t the total return take care of itself?”
That’s a very good and often misguided question. The important thing to understand is that the different forms of returns are not independent from each other. When you decide to purchase an investment property strictly because it produces a certain cash-on-cash return, you are inadvertently impacting that property’s ability to produce the other forms of return.
For instance, if you buy an investment property in a lower quality neighborhood, that will likely produce a higher cash-on-cash return than a property located in a higher quality neighborhood. This makes practical sense since a property in a lower quality neighborhood carries with it a higher investment risk and therefore demands a higher return.
At the same time, the quality of the neighborhood determines its appreciation rate as well as the turnover rate. Therefore, when you buy a property because it satisfies your cash-on-cash return threshold, you’re also making the decision to accept a lower appreciation rate and higher turnover, which account for the majority of your total returns on the property.
Which metrics do you weigh most heavily when making buying decisions? Why?