There’s been quite a bit of interest and discussion in the BiggerPockets Forums about the differences between the cash on cash return and the overall return, which one is more important and what makes for a good return in the context of rental properties or apartment buildings.
Let’s discuss each in turn.
How to Purchase Real Estate With No (or Low) Money!
One of the biggest struggles that many new investors have is in coming up with the money to purchase their first real estate properties. Well, BiggerPockets can help with that too. The Book on Investing in Real Estate with No (and Low) Money Down can give you the tools you need to get started in real estate, even if you don’t have tons of cash lying around.
What’s the Difference Between the Cash on Cash Return and the Average Annual Return?
Zillow ranked Oklahoma City as the Top Area Where Mom-and-Pop Landlords Make the Most Money.
Assuming you bought an average house for $120,000 in 2009, put 20% down and financed the rest at 4.5% over 30 years, Zillow says that the spread between the rental income and your mortgage payment is a gross profit of $536 per month. Deduct from that $100 of property taxes and $30 insurance, and you’re left with $406, which we’ll call our monthly cash flow. Note that for underwriting purposes, you should also include other expenses, like a home warranty, maintenance & repairs, leasing costs and a vacancy factor, but for the purposes of this exercise, we’ll leave those off.
In any event, our annual cash flow is $406 x 12 = $4,777. (BTW, you can follow along and check my math with the BiggerPockets Rental Property Calculator).
What was the cash you invested to close on the house? You had to put 20% down, pay 3% in closing costs, and you did $2,500 in light renovations to get the house rent ready. In all, you had to come up with $30,100 in cash to buy this house.
Your Cash on Cash Return (or COCR for short) is the annual cash flow divided by the cash you invested to buy the house. So: $4,777 / $30,100 = 16%
Let’s talk about the overall return. Let’s assume that you could resell the house in 2 years for $140,000 because you bought it right, and the property appreciated a little bit as well. When you sell you’ll have to pay 3% closing costs, 6% commissions, pay off the mortgage and deduct the cash you initially invested. After punching all of this into a spreadsheet, you’re left with a net profit of just under $2,849.
But in addition you had 2 years of cash flow totaling $4,777 x 2 = $9,614, and if you add that to the profit from the resale, your total profit is $12,463. The overall return is then your total profit ($12,463) divided by the cash you invested ($30,100) which is 41%. Since you held the property for two years, your average annual return is 41% divided by 2 which is 20.5%.
So you’re making about a 16% return on your money each year (the COCR), and your overall return after you sell the whole thing after two years is 21% per year.
Which is More Important: the Cash on Cash Return or the Average Annual Return?
It depends on what you’re looking for.
If you’re looking for income to replace your job, you’ll likely want monthly cash flow. You’re going to look for a high cash on cash return, and you may OK with the lack of any upside (as long as the property value isn’t going down!). It looks like you’re headed to Oklahoma City!
If you’re good on the income side, you may be happier with compounding your money by appreciation. This means you could buy in hotter areas, where the cash flow is minimal but the appreciation potential is enormous. Check out San Francisco! Or flip some houses!
The nice thing about commercial real estate in particular is that you can build value in ANY market, as long as you can increase the net operating income of the property. You could buy an apartment building at a fair market valuation on current financials and then increase the rents and decrease expenses. Doing so increases the value of the building, sometimes substantially.
What’s a “Good” Return?
This is a difficult question to answer because it depends on you, your investors and the kind of deals you’re doing.
For example, your friend and family investors may be happy with a 10% average annual return, but a more sophisticated investor may not consider anything below 20%. In this case, you may be looking for stable, high-yield commercial property for maximum cash flow, but with no or little upside. Or perhaps you’re a developer who will face 2 years of negative cash flow, but you’re projecting a much bigger upside.
Based on conversations with other apartment building investors and the BP Forums, it appears that a 10% cash on cash return for this asset class is something to strive for. If you can’t achieve that on day 1, then get there as soon as possible thereafter. Investors typically like an 8% preferred cash on cash return plus some upside equity.
A Healthy Mix of Cash Flow and Upside
On the single family houses, I always loved the lease option strategy. You buy a house under market (but not crazy under market), put a lease option buyer in there who pays you an upfront option fee and possibly a higher-than-market rent to get some rent credits, and then he buys it at a higher price than you bought it WITHOUT any broker commissions. What a fantastic model if you’re into single family houses!
On the apartment building side, I like the combination of some cash flow, adding value over 3-5 years and doing a cash-out refinance that returns part or all of the cash initially invested (taking the risk off the table and allowing you to reinvest the money) and then holding it indefinitely.
As Minh Le put it in a recent BP Forum post, “There is no right or wrong answer. Cash-flow gets you off the rat race while appreciation builds your wealth.” And Troy Fisher wrote “we all have different End Games, and you’ve got to plan and dream to your own.”
What kind of returns are you looking for? What are you actually getting?
Leave a comment below!