Cash-On-Cash: Lots of misunderstanding out there

[John McAuley]

I see a lot of people saying things like "My cash on cash return is 12% on this property and that's a lot better than my mutual funds have been doing in the market."  I get the impression that they are comparing a 12% return that isn't compounded, with an 8% or so return that is compounded and thinking they are a lot better off.

If you bought a $100K rental property, put 20% down, and generated a 20% cash-on-cash return with that property for 10 years, you would end up with about $60K total ($4,000 x 10 years, plus initial investment).  If you took that same $20K and invested it in the market, you would need to generate a compounded return of a little over 11.5% to reach that same amount.  The point is that the two are not comparable and I hear a lot of conversations among real estate investors (maybe newer investors) where I don't think many of them understand that.

Obviously for this example I didn't include any rental income that would be reinvested, which essentially is where you would get your compounding from. But you need to make sure you really understand that difference to truly evaluate the opportunity cost. If you are going out there and buying rental properties with a target of a 12% COC renturn and planning to supplement your income with the rental profits instead of reinvesting, you might as well go put it in a mutual fund with 8% returns. It stresses the need to go for much higher cash-on-cash returns, which means putting the work in to find the truly great deals.

Disclaimer...I know we didn't consider appreciation, pay down, and tax savings here.  Just trying to make the point of making sure you really understand cash-on-cash if you are going to use it as one of your determinate metrics.  I'm not an accounting or finance guy so I may have my terminlogy wrong, but am I right in general here?