Understanding Multifamily Words & How We Use Them: Cash on Cash Return

Cash on Cash Return

Cash on cash return is a simple performance calculation, but very important to real estate investors. Very simply, it can be calculated as the before taxes cash flow divided by the initial equity investment.

Cash on Cash = Annual (before tax) Cash Flow/Total Equity

Suppose you are purchasing a multifamily property for $1,200,000 and you are able to secure a commercial loan for $900,000. The $900,000 would represent a 75% LTV (loan to value rate). The remaining equity is $300,000. Let us assume that you estimated a year 1 cash flow of $50,000 (before taxes). Where does the cash flow figure come from? It is derived from an analysis of past performance as indicated in the real estate proforma. Based upon this example, we would calculate the cash on cash return as follows:

Cash on Cash = 50,000/300,000 = .1667 or 16.67%

Why is the cash on cash number so important? It gives investors a projection of the return they can expect on their money each year. Essentially, it is a measure of stability. So, for the example above, equity investors could anticipate a 16.67% return on their investment for the first year as long as the cash flow projection is accurate. Cash on cash return are typically projected for each year you are planning to hold a property based upon estimates of future cash flow.

What are the sources of cash flow and how do we analyze it? Cash flow comes from the annual gross rent collected and other sources of income (pet fees, laundry, parking, etc.). From this number we have to subtract operating expenses, any debt service, and vacancy. The resulting figure is your annual cash flow.

Investors are not only are looking for increased valuation (wealth) at the time of sale, but also for yearly projections of cash flow. As such, cash on cash return can be an attractive metric to use when seeking out investors. It is particularly useful as a screening tool to compare the cash flow return of similar properties.

However, using cash on cash return alone can have some significant limitations of which we need to be aware. Because this calculation is based upon yearly pre-tax projections, there could be some inaccuracies in return actualized once your accountant completes your tax return.

Additionally, as you pay down the loan, the amount of the equity in the property will actually increase. In our example above, over time the $300,000 in equity would increase as the loan principle is paid. This increase would change the total equity or denominator in the equation, making the cash on cash return less accurate. The first year of cash on cash return is likely to be the most accurate.

We believe that cash on cash return is a valuable tool to assess property and to estimate stability of cash flow for potential investors. However, we feel that it should not be used alone. Cash on return is a solid metric to use in combination with other metrics, such as IRR and Cap Rate, to provide more a more comprehensive analysis and projection for investors.

This is the second part of a mini-series on our website www.jcgcco.com

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