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Cash on Cash Return, Understanding When to Use it and Why it can be a Bad Metric When Used in Isolation.

Cash-on-cash return is a useful metric for real estate investors to evaluate the profitability of their investments. To understand cash-on-cash return, it is important to first understand annual pre-tax cash flow and how to calculate actual cash invested.

Annual before-tax cash flow includes all the income generated by the investment, such as rental income, minus any expenses, such as property taxes, insurance, property management, and maintenance costs. Total cash invested includes the initial investment, plus any subsequent investments made to maintain or improve the property.

To calculate actual cash invested, an investor needs to consider not just the initial investment in the property, but also any subsequent investments made to maintain or improve the property. This includes any money spent on repairs, renovations, or upgrades, as well as any additional funds invested to acquire additional units or properties.

Once an investor has determined the annual pre-tax cash flow and the actual cash invested, they can use the following formula to calculate cash-on-cash return:

Cash-on-Cash Return = Annual Pre-Tax Cash Flow / Actual Cash Invested

Example of Calculating Cash on Cash Return:

Suppose an investor purchases a rental property for $200,000 and puts down $50,000 as a down payment. The investor spends an additional $25,000 on renovations and other expenses. The total cash invested is $75,000. The property generates $20,000 in annual before-tax cash flow. The cash-on-cash return is calculated as:

Cash-on-Cash Return = Annual Before-Tax Cash Flow / Total Cash Invested

Cash-on-Cash Return = $20,000 / $75,000

Cash-on-Cash Return = 0.267 or 26.7%

What Is a Good Cash on Cash Return Rate?

A good cash-on-cash return rate depends on the investor’s goals and the current market conditions. Generally, a cash-on-cash return rate of 8% or higher is considered good for rental properties, while a rate of 12% or higher is considered excellent.

Cash on Cash Return vs. ROI – What’s the Difference?

Cash-on-cash return measures the return on cash invested in a property, while ROI (return on investment) measures the return on the total investment, including both cash and non-cash components. ROI takes into account factors such as appreciation and tax benefits, while cash-on-cash return focuses solely on the cash income generated by the investment.

What are some Limitations of CoC?

While CoC is a simple and straightforward way to measure return on investment, it has several limitations that make it a bad metric to use in isolation. Some of these limitations include:

  1. Ignores the time value of money: CoC does not take into account the time value of money, which means it does not consider the fact that a dollar received today is worth more than a dollar received in the future. This means that CoC can overstate the true return on investment.
  2. Ignores non-cash expenses: CoC only considers cash flow and does not take into account non-cash expenses such as depreciation, which can significantly impact the overall profitability of an investment.
  3. Does not consider property appreciation: CoC only measures the cash flow generated by the property and does not take into account the potential for property appreciation over time.
  4. Does not consider taxes: CoC does not take into account the impact of taxes on the profitability of an investment.

To evaluate the true profitability of an investment property, investors should consider other metrics in addition to CoC. Some of these metrics include:

  1. Internal Rate of Return (IRR): IRR is a more comprehensive metric that takes into account the time value of money, non-cash expenses, property appreciation, and taxes.
  2. Net Present Value (NPV): NPV is another comprehensive metric that takes into account the time value of money and considers all cash flows generated by the investment property, including the initial investment and any future cash flows.
  3. Cash Flow: Investors should also evaluate the cash flow generated by an investment property on a monthly, quarterly, and yearly basis to ensure that it is sufficient to cover all expenses and generate a profit.
  4. Cap Rate: Cap rate is a metric that measures the ratio between the net operating income of a property and its purchase price. It can be used to compare different investment opportunities and to determine whether an investment property is generating a competitive return.

Overall, while CoC can be a useful metric to evaluate the return on investment of an investment property, it should not be used in isolation. Investors should consider other metrics such as IRR, NPV, cash flow, and cap rate to ensure they are making an informed investment decision.


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