PSA: Investors, DON’T Base Your Buying Decisions on Cash-on-Cash Returns Alone

by | BiggerPockets.com

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?

cash-on-cash return

Related: The Ultimate Analysis: Cash on Cash Return vs. Overall Return

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:

  1. Cash Flow
  2. Debt Paydown
  3. Appreciation
  4. Depreciation

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: 

  1. A lower effective tax rate,
  2. No taxes on the income, or 
  3. 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 a very easy to calculate number so it makes decisions simpler. But it’s an incomplete measure because it does not account well for the 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% 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% 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%.

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
-$20,000 $2,000 $2,000 $2,000 $2,000 $2,000 $2,000 $2,000 $70,318

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.

Related: Cash on Cash Return: What It Is and Why It Can Be Deceptive

The total return (internal rate of return) is 23.3%. The cash-on-cash return is less than half (43%) of the total return—and yet most investors use that measure to make property decisions.

cap-rates-calculate

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 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.

What metrics do you weigh most heavily when making buying decisions? Why?

Comment below!

About Author

Erion Shehaj

Erion Shehaj helps successful professionals achieve financial independence using the Blueprint Real Estate Investing™ strategy. By combining the principles of robust financial planning with quality real estate investments, Erion shows ordinary people how to replace their salary with passive income and retire early to live life on their terms. Over his real estate career of 13+ years, Erion has helped his investor clients purchase $90M+ in real estate assets to build robust real estate portfolios and streams of passive income. In addition, Erion has been involved in successfully rolling out small multifamily new construction projects across Texas. Erion has written extensively about long term real estate investing and business in several publications like BiggerPockets (since 2013), Investing Architect, American Genius, Geek Estate and more.

23 Comments

  1. Costin I.

    Debt Paydown and Depreciation are clear amounts, as they are determined by the loan parameters and the tax appraisal. Cash Flow can be approximated to a good extent and can be tracked on a regular basis.
    But Appreciation is a promise, you can hope for it, and you can make a calculation based on historical or simple wishing, but there is no guarantee that will be the result.
    So, if the IRR is dependent on a selling date, the appreciation amount, and the cash flow up to that point, how is that a better measure of return or performance? What if you don’t plan to sell the property for a few decades or plan to pass it to your heirs?
    C/C ROI can be estimated at the beginning and verified on an annual basis. Chances are, if the rents increase, the cash flow should increase too, giving you better C/C ROI. But do/should you include the loan paydown in it, the increase in equity? Because that will pull down the C/C ROI.
    I agree the C/C might not give you the best measure, but I think the same applies to IRR too. And if so, what else do you use to judge how good of an investment a deal might be?

  2. Erion Shehaj

    Hi Costin

    Thanks for the thoughtful comment.

    Property appreciation is certainly not guaranteed – just like cash on cash returns. 🙂
    When you’re assessing a property before you purchase it, you have to make assumptions about how the “movie will play out” when the year is over. For instance, you can assume a certain rate of vacancy or a certain amount toward repairs. But what happens if by some freak accident, you need to replace the air conditioner on year 1? I’m pretty sure the repair allowance for that year won’t be $4000 so your real cash on cash will not match your pro forma cash on cash return.

    The point I’m making in this article is that in retrospect, we can do a dissection of every investment with the benefit of hindsight. In any given year, the appreciation rate cannot be predicted but if you looked at the area over 10 years, you’d have a better idea. And if you look at an area over the last 3 decades, you idea would begin to solidify even further. So yes, no guarantees but a fairly reliable number to be sure.

    • Costin I.

      Hindsight is always 20/20. The article is titled “Investors, DON’T Base Your Buying Decisions on Cash-on-Cash Returns Alone” – that doesn’t gel with the “in retrospect” idea of the content. Basically, you are saying “you’ll know how good was the buy decision when you’ll sell in the future”.

      • Erion Shehaj

        When it comes to appreciation, “the retrospect” is the idea that any location has a history that has already happened. For example, pick any 10 year period in Houston in the last 30 years and the average appreciation rate over that period is no less than 3.23%. There are periods when the appreciation rate is higher but 3.23% is pretty established.

        My point is that while running numbers on a property in Houston, you can safely assume an appreciation rate of 3.23%. There’s no guarantee that the appreciation rate next year will be that. It could be higher or lower. But over the next 10 years, it’s a safe assumption to make.

        I should further qualify the headline (which I didn’t write) to say that LONG TERM investors should not make decisions based on cash on cash alone.

        • Tom Croyle

          I somewhat agree with this philosophy; however, investors today are focused on cash flow and its overall composition of value because of where we are in the real estate cycle. It’s realistic to speculate that rising interest rates will decrease borrowing power, sales volume, and property values in the future, making appreciation estimates feel more speculative.

          By focusing on the cash flow, you can confidently pencil out a deal regardless of property cost. Then, any appreciation is seen as a “bonus” instead of the value proposition that makes the deal work.

  3. Patrick Horgan

    How do you use the IRR when analyzing a deal to purchase? From what I can tell the IRR is different from C/C ROI in that it accounts for appreciation and the sale of the property. What should one assume the future sale date of a property to be? If one is buying for cash-flow it is likely they will hold it as long as it cash-flows.

    I see your point that the IRR gives a more complete analysis of the property in hindsight, I am curious how you would recommend using it for future purchases. Thanks for the article!

    • Erion Shehaj

      Patrick, great question.

      IRR accounts for all forms of return which is why it’s a more complete metric.

      The future sale date of your property for the purpose of calculating IRR depends on the individual investors time horizon. If you’re a LONG TERM investor as I am, you should probably use 10-15 years. I should say that the shorter the investing time horizon the more IRR and Cash on Cash conflate provided the property is purchased at market value. If there’s captured equity from purchasing the property below market, again IRR is the far better measure.

  4. kris patel

    As a retiree COC was best for me. No hope for appreciation. What you have done?
    Bought Walgreens STNL new bldg @ 7.35 cap rate, 282k/ yr income nnn for 24 yrs co-terminus with lease. 1031x, Down Pygmy 800 k. Mtg at fix rate 24 yrs @ 6.11%. In 2010 could get financing at debt cob ratio of 1.05!!
    Put all 800 k fun to get COC approx 4.50%. Put 0 down, negative cash flow.
    Lease 2010-2034 plus 50 Annual option. Did for estate planning too.
    Thanks

  5. Llewelyn A.

    Great Article but you won’t change the minds of the Cult of Cash Flow Now People.

    There really is only ONE analysis to make, and that’s the IRR calculation you mention in your article. You do not even have to assume Appreciation. You can simply set the Appreciation to ZERO.

    So in your example, assume your Investment of $20k in Year 0 is the amount out of your pocket for a purchase of a $100k Investment that generates $2k per year.

    If in year 8 when you sold the building, we can assume from the Mortgage Balance reduction, you get sales proceeds of $30k. So the cash flow looks like this:
    1: -$20k
    2 to 7: $2k
    8: $30k
    IRR = 13.12%

    The point I think you are making is that using the IRR, you CAN add any CASH FLOW you want, whether or not it’s Mortgage Balance reduction, Cash on Cash Return, or Appreciation.

    The Investor who understands the complexity of the investment takes EVERYTHING into consideration, including all of those.

    The problem with those that use only a simple CoCR formula is that they don’t get the full picture of the Investment and don’t really understand it well enough.

    There should be MORE than one reason to buy an investment. CoCR is just one of those.

    When I buy, I consider that I want to buy in a location that will have positive future potential, such as a new train station that goes directly into Manhattan.

    Many Investors that use a simple CoCR do not consider the Future not because they think it’s gambling. The truth is if they understood how to calculate it and what these future calculations actually mean, they would understand to consider it.

    Every Wall Street Analyst uses Future calculations such as Compounded Annual Growth Rate (CAGR), IRR, Free Cash Flow Growth, etc.

    The readers of this Article should really keep their minds open that maybe, just maybe, if you studied these calculations, you can understand why Professional Investors use them and how important they should be in your investment decisions.

    One last word. Many people who do not understand these more sophisticated formulas may have made money. But they think they really understand that it’s because the only formula they needed was a simple CoCR formula.

    The reality is that if the Economic Tide comes in, all boats float. If your timing is wrong, your CoCR may not protect you.

    Where the IRR helps is that you are FORCE to think about the future and the economic policies and events that will affect the future of your Investment. CoCR is a calculation that’s done for only today’s cash flow and there is no thought to the future.

    Therefore, you are most likely to get burnt by unexpected events with CoCR than by IRR.

    Just my opinion, of course.

    • Justin R.

      “Where the IRR helps is that you are FORCE to think about the future and the economic policies and events that will affect the future of your Investment. CoCR is a calculation that’s done for only today’s cash flow and there is no thought to the future.”

      Yes, this. You won’t know what the actual appreciation rate will be, or the capex you’ll need to make, or the actual occupancy percent, or the actual real estate taxes, or future rent growth … and that’s fine. By forcing an investor to estimate all those variables, and run the IRR with different ranges and different scenarios, we learn what variables any given deal is most sensitive to. Identifying and quantifying RISK in this way is what prudent analysis is all about.

  6. Michael P. Lindekugel

    in my experience most smaller investors do not calculate cash flow correctly. the most common mistake is confusing interest and annual debt service. interest is a reduction of cash on the balance sheet and increase of OpEx on the statement of operations which is an accounting and tax reduction of net income and taxable income. Annual Debt Service ADS (principal and interest) has a balance sheet component. it is a balance sheet reduction of cash for the ADS and a reduction of the loan balance and a OpEx increase for the interest. the cash flow statement is a separate financial statement from the statement of operations.

    what I did not see mentioned is that CoC is nothing more than the year one calculation in IRR. CoC is a non discounted cash flow calculation of the ROI for year one. when cash flow is incorrect then CoC is incorrect. the second big mistakes i see smaller investors make is they do not calculate the after tax ROI or after tax IRR. the after tax IRR takes into account the tax treatment items. a property in which most of the value is in the land means there is little depreciation to shield Net Income from taxation. the tax liability can quickly eat into the IRR making it a bad investment. I have seen veteran real estate brokers make the same mistakes.

    IRR can be calculated using low or no appreciation which mitigates some market risk. the weighted component of the IRR then comes from cash flow from rental operations with little or no cash flow from the disposition of the asset. there is still rent increase risk which is a prediction. OpEx risk needs to be accounted for. the opposite can be done for a high risk opportunity such as apartment development.

    i think every investor should evaluate a set of financial calculations for decision analysis. capitalization rate, CoC, IRR, NPV and in some cases MIRR. BTW, capitalization rate has zero to do with ROI or interest (same thing)

    • Erion Shehaj

      Michael

      I think your point about after tax calculations is absolutely powerful. I was trying to keep this post out of the “weeds” as much as possible and offer a more simplistic illustration. But, you’re correct, after tax IRR is what truly encompasses the full investment picture.

  7. Eric Jones

    It’s amazing to me how many of these comments are people who disagree with the author. He is spot on. This is investing 101, whether it be real estate, stocks, bonds or any other investment. Total return has different components as the author points out, and IRR/discounted cash flow analysis accounts for these various forms of returns over the lifecycle of the investment… For those who are preoccupied with strictly cashflow, try investing in some high yield junk bonds with yields over 20%… you’ll quickly learn the importance that asset quality and appreciation potential have on your total return.

Leave A Reply

Pair a profile with your post!

Create a Free Account

Or,


Log In Here