Cash-on-cash return is a key part of evaluating commercial real estate investments. But is it enough?
Most investments, such as stocks, are assessed by return on investment, or ROI, but because you can’t know how much a rental property will bring you in total before you sell it, using an ROI to evaluate a commercial real estate investment won’t give you an accurate assessment.) Cash-on-cash return, calculates the cash yield on a property investment. It is also occasionally called the equity dividend rate.
The Cash on Cash Formula
The divisor in the ratio—total cash invested—is the amount of cash you’re planning to invest out of your own pocket. It’s the overall purchase price for the property, minus any loan amounts. The dividend—annual before-tax cash flow—requires more work. It’s calculated based on the real estate proforma, or cash flow projection, for the property.
Let’s look at how this formula works in the real world. You’re currently evaluating three different commercial properties that you have interest in, all around the same price range. You know that you’ll be able to secure a loan for 1.25 million on any of the properties.
You’ll be able to acquire Property 1 for a negotiated $2.5 million. You know that your total cash investment will be $1.25 million. After looking at potential and effective rental incomes, expenses such as property taxes, insurance, maintenance, you determine that your cash flow before tax the first year will be $250,000. The cash-on-cash return for Year 1 would be 20 percent.
Property 2 is less expensive; you can purchase it for a negotiated 1.85 million. Your total cash investment will be 600,000. The proforma shows that your pre-tax cash flow for year one will be $85,000. That’s a 14 percent cash-on-cash return for Year 1.
Property 3 falls in the middle. The negotiated purchase price would be 2.1 million, with your total cash investment at $850,000. Taking into account all potential incomes and expenses for the first year show your cash flow before tax will be $195,000. That’s about a 23 percent cash-on-cash return for Year 1, the best rate of the three properties for the first year. Continuing to calculate cash-on-cash return for future years, as long as you plan on holding the investment, will offer a comparative view of the properties’ return rates.
A Few Limitations
Looking at cash-on-cash return is an easy and fast way to evaluate investments, but it does have limitations. First, it’s not a promised return, just an overview of potential, estimated returns over the course of an investment. If operating cash flows grow, the investment rate can turn out to me much better than what’s shown by the cash-on-cash return. Conversely, if leases expire a few years after the purchase, and operating cash flow declines, the cash-to-cash rate could be much lower than projected.
It also doesn’t account for effects of income tax or changes in property values, as well as reductions in loan principal. It merely shows the effects of leverage, showing how it can increase the return on equity, and with it the cash flow to you, the investor.
Cash-on-cash returns are a perfect starting point to your investment evaluation. Other facts to consider include income taxes, risk levels, and alternative methods of financing. If, after studying the return rates, your interest in a property grows, you should then also get more in depth in your analysis, looking at a discounted cash flow analysis that predicts incoming and outgoing future cash flows.