One popular metric for measuring the performance (present or future) of a real estate investment is Cash on Cash return. Cash on Cash Return gives an investor a rate of return on the amount of cash invested in a given property. While this is not a perfect measure of return on investment it is a good way to compare the potential return between two given investments or properties.
Cash flow is another popular measure of performance and it is the factor most investors start with when considering a property for purchase. It is also a factor in the Cash on Cash Return equation. Cash flow does not just refer to rents received* but the amount remaining after expenses are paid. Those expenses may include: mortgage payments, utilities paid by the owner, repairs, insurance, property taxes, home owners association dues, landscaping and property management. It is important to remember that each property is unique and investors would be wise to do their homework to determine not only what the property is likely to rent for but also what expenses will be incurred.
The next factor in the equation is how much cash out of pocket is invested. Each investor has their own threshold for how much cash they can or are willing to invest in any given property. We have some investors who don’t feel comfortable with anything less than 100 percent of the purchase price coming from cash while others are perfectly happy with the minimum down payment required by their lender. Either way is fine but the amount of cash invested will affect the rate of return as illustrated below.
Now we are ready to find out what the cash on cash rate of return is. The equation used is: Cash on Cash return = annual cash flow (income-expenses) / total cash invested.
Let’s use an example of a three bedroom house with a purchase price of $175,000. We could reasonably expect that house to rent for $1295/month resulting in annual rent income of $15,540. In this case our investor will finance 75 percent of the purchase price and make a cash down payment of $43,750. If the mortgage payment (principal, interest, taxes and insurance) comes to $882.99** and other expenses come to $175.00/mo. then cash flow will be $237.00/month or $2844.00 annually. That may not seem like much but it works out to 6.5% Cash on Cash Return. Now lets assume all other factors are the same but with an all cash purchase. Under this scenario cash flow would be $1120.00/month ($1295-$175) and Cash on Cash Return would be 7.7%.
Cash on Cash Return is a great tool to use when evaluating a real estate investment but it is important to keep it in perspective and remember that it is a snap shot of one year. It does not take into account the time value of money or gain/loss when the property is sold.
* If you will be borrowing money to purchase an investment property, your lender will use 75% of expected income but 100% of expected expenses for qualifying purposes. In the Bend, Oregon rental market right now investors can essentially expect 99% of income for planning purposes. In most cases, the property management side of our company is able to minimize vacancies to about one week between tenants unless the unit requires extra cleaning or repairs.
** Assumes interest rate of 4.75% based on today’s rates, property taxes of $2200 annually and insurance of $35/month.