You have money to invest or have leveraged money to purchase a cash flow multifamily property. One of your concerns for the investment is the rate of return you could receive from the property. Will the rate of return on your equity in the property be equal to or hopefully better than some other investment, like stocks or a US Treasury Bond? An investment measure that could answer that question is the Cash on Cash Return or CCR.
A lot of emphasis has been placed upon the CCR by investors, accountants and other real estate professionals. It has been said that when analyzing the long-term performance of a property’s investment, the CCR is most important. This may or may not be true.
My first reaction, to any statement that points to one ratio or metric as the most important, is suspicion. Really, is one ratio all you need to make an investment decision? I can hear the experienced investors here at BiggerPockets shouting a very loud NO! Making decisions with large amounts of investment dollars cannot be reduced to one quickly calculated ratio. If it were that easy the number of discussions, here at BiggerPockets, on evaluating a property would be greatly reduced.
Real estate investing and property analysis requires more than just one ratio. Analysis requires working with “the numbers”; making educated assumptions and then arriving at plausible decisions. In order to do the analysis, we must fully understand the features or values that make up the ratios or metrics within the analysis. It is time to shine the light upon the Cash on Cash Return ratio.
What is the Cash on Cash Return
The Cash on Cash Return is a ratio based on the annual cash flow divided by the equity you have invested into the property, the formula is;
= Cash Flow / Invested Equity.
You will usually see the CCR in a cash flow analysis worksheet, after the Before Tax Cash Flow calculations.
The equation is a simple arithmetic problem that could be done in your head or with a calculator. If you are using a worksheet for a cash flow analysis, the CCR is one of the easiest formulas to enter.
Apply the CCR equation to a fictional apartment building with an annual cash flow of $100,000, where you invested $1,000,000. You probably have the answer already;
100,000 / 1,000,000 = 10.00%
A 10% return on your investment dollars of $1,000,000. All you need now is to find an apartment building with a $100,000 annual cash flow, easy, clean and quick. Buying an apartment building is so easy anyone, even with no money to invest can do it. I hope you realize the previous sentence was taking a jab at the late night infomercial real estate gurus.
Cash on Cash as a Comparison
Let’s go back to the example of the 10% return on the apartment building. With that 10%, you can compare the return against other investments in order to help you decide whether the multifamily property is worth your investment dollars. With the 10% CCR, what would the return be on a CD, stocks, bonds or other investments? How does the multifamily compare to the other investments?
In the above example, a 10% return, on the surface seems to be a good investment. What factors can influence the calculation of the Cash on Cash Return? Understanding the factors involved with the annual cash flow and the initial equity could affect our assumption of the CCR’s value.
Factors that can Influence the Cash on Cash Return
A property has large annual cash flows over an extended period of time. Large cash flows could also mean high cash on cash returns. If you were in the market for this property, the returns over the years would lead you to think that this would be a good investment. Before jumping to this conclusion, you should ask why the property has such large annual cash flows. What if, the property has a number of deferred maintenance issues? How old is the roof, when were the last repairs done to the heating and cooling systems, how old are the electrical and plumbing systems and the presence of a security system if needed?
Properties with deferred maintenance issues will naturally have a higher cash flow. Money is not going to the correction or maintenance of the property. But if you purchase that property based just on those high cash on cash returns, guess who will be stuck with the delayed repairs? Not understanding the calculations or factors that affect the calculation of investment metrics can easily cost you in the end.
Here is another scenario. You are interested in another multifamily property and your agent has obtained the first year of operations from the owner’s Proforma. Using this data you have made some projections for the future years based on your assumptions for the property. How sure are you of your assumptions? What would happen if they were wildly incorrect? How would that affect the cash on cash return?
No one can predict the future. No one can be 100% accurate on any assumptions made in real estate investing. However, we all must make assumptions based on prior historical data and experiences. You must be very careful if you will base your purchasing decision on the Cash on Cash Return 5, 10 or 20 years into the future.
Twenty years from now, how can you compare a CCR to a US Treasury Bill? Cash on Cash Return is most effective in the first year of operation for a property. In the first year you accurately evaluate the income that the property has produced. After the first year, assumptions have to be made about future income. Realize that the CCR does not account for the time value of money principle. A dollar today is more valuable than that dollar in the future. Consider that the Cash on Cash Return will only be as strong as your assumptions.
The Cash on Cash Return could be valuable when comparing other investment options. You have to remember the factors that could affect the calculation of the ratio. Used with other investment measures and ratios, the CCR is another return that could assist you in your investment decision process.