Many real estate investors are heavily reliant on the cash-on-cash return metric to get an idea of how their portfolio is performing. However, the problem with cash-on-cash return is when it’s the only metric you use to evaluate your portfolio or investing options. Therefore, it’s important to understand what cash-on-cash return achieves and how it can be properly used to make a rough estimate of the quality of an investment.Let’s get right into it.
What is Cash-on-Cash return in Real Estate Investment?
Cash-on-Cash return is a quick way to calculate the cash flow of an investment. It gives a rough estimate of how well a property performs given its initial investment. To calculate Cash-on-Cash return, simply take the annual cash flow you get from your investment and divide it by the amount of actual cash you have invested. However, the pre-tax annual cash flow is hard to calculate, which in turn makes it easy for investors to end up with an incorrect Cash-on-Cash return.
What is Annual Pre-Tax Cash Flow in Real Estate Investing?
To get an accurate cash-on-cash return, you need to ensure that you account for the annual pre-tax cash flow. Therefore, to correctly calculate your annual pre-tax cash flow, be mindful of the following:
- Gross Annual Rent: This is the maximum amount of rent you expect to receive from your property throughout the year. To calculate it, simply multiply the monthly rent by 12.
- Additional Property Income Sources: Rent is not the only way your property generates cash. In other words, your property can net you additional income through non-refundable deposits, parking space rentals, and flat charges for utilities.
Add the two up and then proceed to subtract the actual vacancy, operating expenses, and annual debt service to get your net pre-tax cash flow.
When Should You Calculate Cash-on-Cash Return for a Real Estate Investment?
Cash-on-cash return helps you understand the return on capital invested. While it does not take asset appreciation into account, it gives a well-defined metric into a property’s cash flow.Additionally, cash-on-cash return only compares your net annual income from an investment versus the original investment itself, thereby making it a great way to measure the effects different leveraging strategies might have. Therefore, you can use this metric to assess the effects of different leverages.
Other more complicated metrics such as internal rate of return or modified internal rate of return can offer better insight into the quality of an investment, but they require more time and effort to calculate. Therefore, in cases where you want to keep your calculations simple and compare property investments quickly, you are better off using the cash-on-cash return metric. And so, you can use it to quickly screen new deals that come your way before jumping into more complicated metrics.
The cash-on-cash return metric is limited by what makes it easy-to-use – its simplicity. Moreover, it does not consider the appreciation of property nor the opportunity costs involved. Therefore, using it as the only metric for property investment is unwise and should only serve as the first comparator when looking at different investment opportunities.0