Why so much emphasis on Cash on Cash return?

35 Replies

I always see people looking for a specific number for their cash on cash return. For example, Brandon likes 12% or higher, and he calculates this by taking the annual cashflow divided by the cash that is invested.

My question is, why ignore the equity that is building in the property? Doesn't that matter? You're not just making cashflow, your renters are also buying you equity that you can later access when you sell the property or do another cash out refinance.

In the 1st year alone with 5% APR on a 30-year mortgage for $100,000 you're not just getting that $2,400-ish cashflow, you're also getting $1,475 in equity, and that only increases every year. Why do I never see anyone taking this into account?

@Nicholas Layton I would have to check my spread sheet but I did take this into account when I calculAted my returns so far from my properties.

I had 3 different return numbers and then IRR for each property to. My 3 different return numbers were CoC, ROI with equity paydown and ROI with equity paydown and appreciation.

I personally like mainly what you were referencing which is ROI with equity paydown.

Some people may not care as much but I care about my net worth as much as cash flow and equity paydown helps with that, so I like to see the whole picture.

For questions like this I also occasionally like to tag @Omar Khan as he often provides good insight to

@Nicholas Layton

I do not think is an issue of ignoring all of the other benefits (debt reduction, equity buildup, depreciation, etc.).  

The single most relevant reason to evaluate cash on cash return is that allows for an easy comparison between different types of investments.  How does the return on your down payment compare if you were to leave the money in the bank, versus purchasing stocks/bonds, or buying a rental property.   

Cash flow pays bills. You can live on it if you have big enough portfolio. Equity does not pay bills unless you sell or refinance. In which case it's a one time event and no future income.

Let's suppose you have no other income. Would you rather have $100K/year cash flow and no equity growth or $100K/year equity growth and no cash flow? 

@Nicholas Layton CoC metric sometimes depends on the kind of property you're getting and what the goal of the investor is. If the property is in a cashflow zone, say C, C+ areas, there's not much appreciation around where I live. So the emphasis would be on CoC. Most investors think of this as a preliminary check to compare between deals. Other metrics do matter when there's scope for appreciation and you're tracking net worth. I like to track equity as well, apart from cash flow, because I could potentially get a HELOC to tap into the equity.

But cash flow is cash flow. Cash on cash is not cash flow.

And here's why cash on cash is weird to me. Let's say you have 200 monthly in cashflow, and $20,000 cash invested. that's a cash on cash of 12%. Well, what if I *do* have another source of income. I can live without that cash flow for a year. So i take all that cash flow and just redirect it back into the account that I got the cash from in the first place so now instead of $20,000 invested I only have $17,600. So now going forward my cash on cash is 13.63%.

Why couldn't you just keep chopping it up like that? I've gone this far in my life without that $200 cash flow so why couldn't I just say for the next 8 years I have $0 cashflow, then in the 9th year after i've fully reimbursed myself the $20,000 I invested now i have infinite cash on cash return because i have 0 cash invested.

I clearly just don't understand this stuff quite yet.

Good observation, taking principal paydown into account, Nicholas. For basic, easy to understand newbie math, COC is the easiest to figure is probably why Brandon references it so often. New folks are his focus most of the time.

The equity build-up (sans appreciation) really comes in to play when you have shorter loan terms like 15 years, or when the loan has aged over about 9 yrs. I have more than one that pay down north of $1200-1400 per month. My primary for example (that has a $900 per month ADU) costs about $1900. We are 'losing' $1000 a month, but the principal paydown is over $1200. Crummy COC, especially since we put $28k down, but good for the balance sheet. I am being 'paid' every month to luxury househack, but would never know it if I only used one little metric in the IRR story. The IRR is the most important measure for me in the end anyway.

But...It can also be used to rationalize a bad purchase or longer holding costs. I left a pending sale vacant for 3 months at the end of last year to be sure I closed this year (for tax purposes). PITI was $970. I probably wouldn't have done it that way if the paydown wasn't over $450. I rationalized an otherwise probably not good decision. Use with care.

I just saw your cf post above. You are welcome to use your cf however you like.  I don't use much of mine to live off of, either.  If restocking your dry powder is the most optimized for you or paying down a higher rate debt, it's all good.  The 10% cf example you used is just that. You won't have an infinite return because you lost full use of your DP for 10 yrs (8 in your example).

Originally posted by @Nicholas Layton :

But cash flow is cash flow. Cash on cash is not cash flow.

And here's why cash on cash is weird to me. Let's say you have 200 monthly in cashflow, and $20,000 cash invested. that's a cash on cash of 12%. Well, what if I *do* have another source of income. I can live without that cash flow for a year. So i take all that cash flow and just redirect it back into the account that I got the cash from in the first place so now instead of $20,000 invested I only have $17,600. So now going forward my cash on cash is 13.63%.

Why couldn't you just keep chopping it up like that? I've gone this far in my life without that $200 cash flow so why couldn't I just say for the next 8 years I have $0 cashflow, then in the 9th year after i've fully reimbursed myself the $20,000 I invested now i have infinite cash on cash return because i have 0 cash invested.

I clearly just don't understand this stuff quite yet.

You're looking at it the wrong way. reinvesting the rental cash flow does not decrease your equity, it increases it. In fact, every penny that you put back into the property decreases your cash on cash return until it is paid off and you are at nearly 0%

to answer your other questions, CoC return is always evaluated because it is what sustains the property. You cannot pay a contractor in equity. In addition, your "equity" is not a realized gain until you sell. until the day you sell your equity is only worth the paper that your deed is printed on, as market values could swing at any moment. Good investors do not ignore the equity paydown, it is simply a factor considered when making purchases.

Originally posted by @Nicholas Layton :

But cash flow is cash flow. Cash on cash is not cash flow.

And here's why cash on cash is weird to me. Let's say you have 200 monthly in cashflow, and $20,000 cash invested. that's a cash on cash of 12%. Well, what if I *do* have another source of income. I can live without that cash flow for a year. So i take all that cash flow and just redirect it back into the account that I got the cash from in the first place so now instead of $20,000 invested I only have $17,600. So now going forward my cash on cash is 13.63%.

Why couldn't you just keep chopping it up like that? I've gone this far in my life without that $200 cash flow so why couldn't I just say for the next 8 years I have $0 cashflow, then in the 9th year after i've fully reimbursed myself the $20,000 I invested now i have infinite cash on cash return because i have 0 cash invested.

I clearly just don't understand this stuff quite yet.

Cash-on-cash is usually calculated based on the original investment. Otherwise, like you've just showed, you get to the point of infinite %% ROI. That means that you are not risking your original principal but you still have equity that is worth something. So, return on that equity would be a more accurate measure.

Profit in real estate comes from (1) cash flow (2) principal reduction and (3) appreciation. Most investors use IRR to capture all three.

Many investors' deal analyzers calculate IRR, CoC, cap rate, and other metrics, each of which are useful and each of which investors have criteria around. Many investors are focused on total profit (IRR) but in this market, many want cash flow for safety; so, they also have certain positive CoC criteria.

A $20k outflow now and a $20k inflow years from now do not wash...the timing of cash flows matters. IRR also handles timing.

Originally posted by @Steve Vaughan :

I am being 'paid' every month to luxury househack, but would never know it if I only used one little metric in the IRR story. The IRR is the most important measure for me in the end anyway.

What is the IRR? I don't think I've come across this, or if I did, I didn't understand what it meant. I believe it means internal rate of return but I don't know what that is.

IRR relies on assumptions of the future value of the money invested today. the market can be good and have a steady increase and you may use that increase in what you feel the income and the sale value of the property may be, but if the market takes a turn, the IRR changes and will not be what you projected. this can be true for any valuation, but with COC your calculations are based on the present value of the money invested and the income earned. If the property you are looking at can yield a higher return on your investment now than any other investment vehicle, then chances are that future returns will be even better because you are not relying on future Appreciation by the time you sell the property but it may happen, some properties my not appreciate much. COC gives you a more steady approach to your return on the investment.

Nicholas, as you pointed out, why ignore the equity that gets built up? you don't, that's more of a bonus for you, that's built in Appreciation, if you want to look at it that way. Personally i like to make sure my properties make me money above my expenses this way i have the money for emergencies or for investing in other properties so that i can earn more money though income and " built in Appreciation" or equity.

Here is an article that may help you: https://blog.realtyshares.com/what-else-can-irr-te...

Equity has zero value beyond bragging rights. It can be there today and gone tomorrow when markets turn.

Equity only has value the day you sell your property or pull out the equity. Never count your chickens before they hatch.

Originally posted by @Thomas S. :

Equity has zero value beyond bragging rights. It can be there today and gone tomorrow when markets turn.

Equity only has value the day you sell your property or pull out the equity. Never count your chickens before they hatch.

3 hours later and nobody has commented on this? 

I beg to differ.  My Geese that are debt free don't have the same problems your geese do, namely a payment.  My golden eggs are bigger and I need less of a flock (along with their tenants and toilets) so I can 10x my nap schedule.

Does equity have zero value in the market? They are called equities after all. Hope you didn't leverage up your RE and buy Bear Stearns when Cramer said they were sound a week before their collapse. Enron? Toys R Them?  How do your stock equities have any value when 'it can be gone tomorrow when markets turn'?  Of course equity has value. 

My ROE on most of my free and clears is 5.8-7%. Not awesome, but also not worth the 10s of thousands it would cost me to put loans on them,; especially the commercial ones.   Now back to my regularly scheduled nap.  Enjoy following CNBC and the latest tariff tweets if you've cashed out your RE equity and bought securities.

Never been a big fan of Cash on Cash.  It is easily manipulated.

All things being equal, which is a better investment?

1.  A zero down owner financed property that generates no cash flow or loses money.

2.  Cash purchase of a house that produces 2% rent multiplier.

The first one clearly has a better COC, but it is not a good investment.

There seems to be a trend to over complicate the analysis. There are very few real numbers and the rest are estimates and manipulations of the real numbers.

How much can you buy the property for?

How much reno is needed to get it online?

How much can you rent it for?

What are the fixed costs – mortgage, tax, insurance, property management

The rest of the numbers are not very important. How many months is 8% vacancy of a year? What is the difference between, reserves, maintenance and cost to turn a unit? You can only count the painting of the same room once. If the roof, A/C and appliances are updated, you will have very little maintenance. 

@Thomas S. You did warn me about agreeing with you on the other thread. Took all of one day to disagree lol.

I’m with @Steve Vaughan . Free and clear is the way for me, over time. In fact I hope to never refinance anything personally.

You need less of them and your cash flow is greater. The first rental I pay off will have a ROE when paid off of 12-13 percent. I’ll take that all day long.

@Caleb Heimsoth  Thanks for the shout out

@Nicholas Layton  Ideally, one shouldn’t only be looking at 1 metric in making a decision. Folks often time use cash-on-cash because that is (A) realized amount (i.e. coming into your pocket, not an accounting gain) and (B) they are using the cash from their investments to fund their lifestyle/other investments. Unrealized equity is just that – unrealized. It will increase your ROE (return on equity) but that’s it.

But unrealized equity is very important especially in primary markets like on both coasts. Capital appreciation in good markets far outstrips any income gains one can make but it is volatile.

Also higher CoC are found the lower down the property chain you go. On average, Class A have lower CoC but higher ROE/ROI metrics, Class C is the opposite.

IRR is a good way of capturing all your concerns. But again, as a sole metric it is not very useful. You have to use it on conjunction with other methods to better understand if an investment works for you.

Most truly wealth individuals, families and institutions prefer investing in a combination of income and wealth producing real estate. True generational wealth, on average, has only been generated in high appreciation markets like NY, California, Boston, Chicago and parts of FL and TX. That's why you hardly hear about any (barring a few major exceptions) real estate billionaires out of the Midwest but RE billionaires out of primary markets are a dime a dozen.

I would personally invest in markets where there is a higher chance of capital appreciation (West and East Coast, bigger cities) vs. income (secondary and tertiary markets). But since I am not a billionaire, I will stick to slowly building my portfolio 😉

Every metric is easily manipulated - CoC, IRR, ROI, ROE. It is up to the investor to decide what combination of metrics provides them the most comfort.

Because it's an investment, and you want to know how the money you invested is performing. Yes, it's only one piece of the puzzle, but you should know what your cash is making.

@Nicholas Layton because it’s the simplest to calculate but does not mean it’s correct. If you want to truly understand the financials of a deal you need to calculate the IRR per tax and post tax

By calculating IRR your essentially determining the interest rate your paying yourself

So in a deal that costs $100k and rent is $1,000 a month and you sell it after 5 years at X. If you had $20k in the deal after 5 years it sells for Y then you can determine what rate you paid yourself with that $20k. You still have depreciation and taxes etc involved to determine final numbers which is why some do pre tax and post tax

Just realize every method of forecasting is just that a forecast.

While people say cash is king, if you have an emergency and need to sell at the right time all that cash which was king is gone. A property that cash flows $10/month but appreciates 5% per year more often than not is much better than a cash flow of $100 in a non appreciating area. This can be sign by where you see more millionaire investors - you think people made more in Boston, New York, dc or California over the past 20 years or Detroit, Cleveland, Baltimore or indianapolis?no knock on those areas but they cash flow but have low appreciation

CoC return is something I look at when projecting how to structure a deal and giving investors options on how to use their cash. However, for me at least, CAP will always be king.

@Nicholas Layton

My question is, why ignore the equity that is building in the property? Doesn't that matter?

Yes of course it matters. Many investors count that factor highly. To some it is not that important. The grocery store does not accept equity as a payment. When I get to the point I can live off my investments, I want to live off the income, not by eating into my equity every year. 

with 5% APR on a 30-year mortgage for $100,000  .   .   .   you're also getting $1,475 in equity,

Yes but if you keep the property only a few years, the small amount of amortization get quickly eaten up by transaction costs. 

I believe IRR is the best way to evaluate on investment. However as mentioned above it is based on assumptions that may not come true.

The bottom line is there is not one perfect answer. Different investors have different philosophies, different goals, different resources and work in different markets. I am a believer in cash flow, but I reinvest all my cash flow. If I lived in CA I would probably focus more on appreciation.

But cash flow is cash flow. Cash on cash is not cash flow.

Oops I missed that. Cash on cash vs cash flow. Cash on cash is only a metric at purchase. The next year it is "return on equity."  Return on Equity is  a very similar measurement but a different one. Good portfolio management means evaluating your return on equity from time to time.  It may make sense to sell and reinvest the returns in something that gives better current returns. 

Again whether to do this is a personal choice. Maybe @Steve Vaughan could make more money if he invested more aggressively but he is happy with his choices. I am happy with mine. You need to find what works for you. 

What is the IRR

As said already IRR (Internal Rate of Return) takes into account all factors of an investment. (OK not risk but that is another topic). It is the return your money is making, while it is invested in the investment. Lets say you buy, then renovate, then collect rents for years, then spend some money on capital improvements, then collect rent for some more years, then sell. That is a lot of money coming and going. IRR takes all that into account.

If an investment has an IRR of X%, then it is the equivalent of having a savings account paying X%. Ok not exactly the equivalent but it means at the end, you have the same amount of money.

you might want to check out

What Every Real Estate Investor Needs to Know About Cash Flow... And 36 Other Key Financial Measures, by Frank Gallinelli. He was on one of the earlier podcasts. 

Originally posted by @Nicholas Layton :

 you're also getting $1,475 in equity, and that only increases every year

Because that isn't guaranteed. Every 7-10 years at or near the peak of the market people think the music will never stop and someone always misses the chair and lands on their …   Cash flow is king because it is the most reliable IMO. Even if you count in long term equity you might be in the next Detroit and in 30 years your building is worth what it was when you purchased it

My degree is in finance - I can calculate, NPV, IRR, ROI, ROE, COC, or EIEIO (yeah, that's from Old MacDonald ...) or any other acronym we have developed over the years to make ourselves sound smart. Financial ratios are great, setting goals and using math to define and measure those goals is great - I think it's smart to take those into consideration. The reality is you never know if an investment is good until 20 years after you make it and have the opportunity of measuring your return against the opportunities you didn't take advantage of. If all of us on here took our money 20 years ago and bought Amazon stock, we would be laughing at real estate investors as schmucks right now.

Just my opinion, but I think many people get too wrapped up in the numbers and forget to enjoy the thrill of the hunt. Searching for deals, networking with other investors, running projects, and building a portfolio that is our own little kingdom in the larger world is what I love about real estate investing. Make no mistake about it, I'm in real estate to build wealth. It has proven over the last 150 years to be a great way to build sustained wealth. With that said, the hustle and grind are fun and exciting. Don't forget to have some fun!

Clearly equity has value. Ask anyone in CA or other high equity markets. And, yes, you can borrow against it... and if you have a good commercial bank, you well may be able to borrow at low or no cost. And am I the only one with partners that accept company equity as payment? That's the point!

Clearly cash flow has value. It's best when it is not taxed and there are no "strings attached" because your cash flow represents pre-tax earnings and (ideally) depreciation expense at or above free cash flow will make your money tax deferred.

From an IRS perspective, paying down your mortgage through debt retirement (principal reduction) isn't income, it adds to equity. It's all good, though, we all know what posters mean.

The bottom line is that there are metrics and measures for everyone, and when investing you need to focus on the numbers that make sense to you and your partners (investors/members) and don't worry about everything else.