Why Cash-on-Cash Return is King

The Cash-On-Cash return is merely the cash profit earned off the cash invested on a deal. To state it more simply, it is the cash we make off of our money. The funny thing is, most investment shops do not focus on this metric. They focus more on the IRR (Internal Rate of Return) or Annual Average Return. Since we invest in more stabilized assets, the average yearly cash-on-cash becomes a more important metric for the JB2 Investments team. In this blog post, we will dig into why that is.

How to Calculate Cash-on-Cash Return

Cash-on-cash Return = Pre-Tax Free Cash Flow / Total Capital Invested

First, let’s dig into how we calculate cash-on-cash. The calculation is relatively straightforward. We start by calculating the net yearly income after vacancy, loss to lease, concessions, and bad debt. We subtract all annual expenses such as insurance, taxes, debt, maintenance, management fee, utilities, payroll, etc. Next, we take that available cashflow for distribution and divide it by the invested capital divided by the money invested. Finally, we model this out for the years of the investment and get an average yearly cash-on-cash return, which is a metric very important to the JB2 Investments team.

Why Cash-On-Cash is a Preferred Metric for Calculating Return

We prefer cash-on-cash because it’s one of the most understandable and straightforward metrics in the real estate industry. We also need to make fewer assumptions than, for example, with IRR. We only have to make assumptions that we will have a modest increase in rents to keep up with inflation and a slightly lesser growth in expenses. These assumptions are always based on past conservative historical performance.

When it comes to IRR, you need to assume what an exit price will be more than five years from now. We all know how much can happen in five years. For example, did we ever expect what happened in 2008 to happen back when it was only 2006? Or did we expect to be dealing with business shut-downs related to a virus? So much can happen. To make an assumption on an exit price, years down the road is genuinely just an educated guess on what may happen in the future market. The IRR is a better measurement when pursuing heavy value-add deals. By doing the heavy lift, you drive the rents up more significantly. This method pushes values up quickly, and IRR(Time is a big factor in this formula) is thus a better measurement for heavy lifts.

JB2 Investments Current Strategy - Slow and Steady

Since the start of the Pandemic, the deals we have been focusing on have been stabler assets where there is cashflow from day one. We think this is a prudent way to invest, based on where we are in the buying cycle.

Over this same period, we have seen that the value-add for us has been operational efficiencies (better record-keeping, new systems, marketing, etc.), expense reductions, and modest rent bumps. Since we are buying more stabilized assets, we are experiencing modest value increases.

Though over the years, the compounding effect can be substantial. For this reason, the cash-on-cash metric is most important.

We subscribe to the model that slow and steady wins the race. This is why the average yearly cash-on-cash metric is most effective on these cashflow plays. We feel it’s the most realistic way to assess how our investments are doing annually while also keeping track of the rolling average cash-on-cash through the years.

The stable asset model also mitigates several risks that come with large construction projects. We still do measure the IRR, but to us, it has less weight overall. We also tend to give a range when it comes to IRR. Since we hope to keep assets longer then the forecasted hold time, the IRR tends to be irrelevant. We will hold longer than the projected hold time if we can cash-out refi most of the capital back to investors.

Wrapping it Up – Why Cash-on-Cash is the Winner

Ultimately, we know some groups out there that throw the IRR function out completely. At JB2 Investments, we like to calculate IRR as another reference point to help ensure we're correctly assessing our deals.

The cash-on-cash, in conclusion, is the winner for us. We have cashflow goals we are trying to reach. Knowing the cash-on-cash return and the numbers behind them help us quickly get a sense of our trajectory towards those goals. It also allows our investors to achieve their own goals and wishes. With cash-on-cash as a key metric, we all realize a clear, concise, and straightforward way to evaluate a project's success thus far.