In a perfect world, investors would have a 100 percent guarantee that their real estate property will make them money. However, part of the investment process is knowing that no matter what type of investment you choose (real estate or otherwise), it’s never a “sure thing.” Fortunately, there are things you can do to maximize returns and reduce risk and to calculate the returns an investment delivers.
For real estate investors, understanding your market (property valuations, job market, etc.) is essential. The ability to view your investment from a variety of perspectives allows you to make educated decisions about your objectives.
Additionally, you should take time before you decide to invest in a particular property to run a few numbers and see if your investment has the potential to pay off. There are several formulas that you can use to determine how your investment could perform.
One formula that can be particularly beneficial is the cash-on-cash return.
What is cash on cash return?
The cash-on-cash return is a measure that values property by calculating annual cash flow to original cash invested. The formula also factors the impact of borrowed funds. The purpose of the cash-on-cash return formula is to help investors analyze new investment properties and to provide a review of returns on a property. The results of the formula can determine an overall return on investment (ROI) over time. You may also hear this referred to as the cash yield.
Typically, investors turn to cash-on-cash returns for commercial investment properties that require a longer-term debt commitment. Because investors must factor in debt, the ROI on commercial real estate is a bit different than other investment options like stocks or bonds.
The cash on cash return provides a number that shows an investor the amount of return they earned or could earn in relation to the amount of money they invested out of pocket. This simple formula is among the most utilized tools by investors to screen an investment in the commercial real estate industry.
How do you calculate cash on cash return?
Calculating cash on cash return is relatively simple. Remember that when you plug in your numbers into this calculation to only use your total original cash investment.
Original Capital Contribution
Where net cash flow is a number derived from net operating income (NOI), defined below, and original capital contribution does not include any debt placed on the property; only the total equity invested.
Keep in mind that NOI is effective gross income minus operating expenses and does not include below the line expenses or debt service, whereas net cash flow does include all of those items.
That number divided by original capital contribution, or cash invested, is the cash on cash return.
Net Operating Income:
To determine your net operating income, you’ll want to include any extra sources of income associated with the property. These could include:
- Pet rent
- Laundry Fees
- Parking Fees
- Late Fees
- Amenity/Service Fees
- Utility Reimbursement Fees
- Storage Fees
To get to NOI, you will need to subtract any operating expenses from your effective gross income. Operating expenses may include:
- Property insurance
- Maintenance fees
- Marketing costs
- Property taxes
- Management fees
Put another way, the total cash on cash return is then calculated using the following formula:
Original capital contribution, or cash invested
Total Cash Investment
Your total cash investment only considers the money contributed to the investment out of pocket. It does not include debt placed on a property as part of the investment. The total Cash investment is calculated based on any money invested in a deal that is over the project’s total debt.
What is good cash on cash return?
A ‘good’ cash on cash return depends on many factors that can include the stage of the real estate cycle during which you are investing, returns compared to other projects in the same geographical area, and your risk-return priorities.
Real Estate Cycle
Typically cash on cash returns will compress, meaning they go down as a cycle lengthens. During the earlier part of an economic recovery, returns will be markedly higher than they are in the latter stages. Returns are typically higher early on because prices following a recession are generally lower due to lack of liquidity in the market, and the perceived risk is higher, as investors are warier following their recent exposure to a recession. As the economy recovers, more money enters the market, pushing prices up and cash on cash returns down. Furthermore, there are usually rising interest rates late-cycle making debt service more expensive and further compressing cash on cash returns. As the cycle extends, the financial pain associated with a recession fades from investors’ memories, and they become more willing to take on greater risk at lower returns.
A great way to determine if a cash on cash return is a good return is to look at how the project you are considering investing in compares with other similar projects. Assuming all other things are equal, however, the cash on cash return of an investment in comparison to other similar projects will provide a decent indication of how projects stack up against each because it also factors into the calculation, management and operational costs.
For example, let’s look at two buildings that are identical in all respects other than that the properties are managed by two different sponsors. The sponsor with less experience and expertise in property management and development will likely spend more to manage the building, whereas the sponsor with more experience will have developed more efficient processes and consequently have lower operating costs while enjoying higher occupancy rates. The latter, more experienced, sponsor, will deliver higher cash on cash returns.
Comparing, therefore, different similar projects’ cash on cash returns and then drilling down on how they were derived will give the investor deeper insight into how good the returns are and, indeed, how competent is the sponsor.
Risk Return Profile
Another important consideration is how much risk are you willing to take and how long are you willing to wait to get a strong cash on cash return. A higher risk ground-up project, for example, will yield zero cash on cash return during the construction and lease-up phase of the project, but then, once net cash flow turns positive, cash on cash returns could outstrip those on an existing, older project in the same area.
The risk-return profile also applies to a value-add apartment investment. Being willing to take on the risk associated with the gradual renovation of a property as tenants move out, units are improved, and rents increase will likely mean that earlier stage cash on cash returns will be considerably lower than later, when the building is fully renovated, rents are maximized, and vacancy rates are driven to their minimum levels.
Benefits of Cash on Cash Return
Cash on Cash Return is a simple formula that provides a picture of immediate returns, providing insight into ongoing passive income and the current yield on your investment. The cash on cash return only reflects results based on ongoing cash available for distribution from a project and does not consider the appreciation of the property’s value overall.
Consequently, while the cash on cash return equation is not a complete picture, it is a helpful gauge for potential investors because it does describe the current yield your investment is earning and so points to immediate income the investor will be receiving.
A cash on cash return will be most beneficial when investors or partners are concerned about consistent positive cash flow. For example, if you wanted to live off the cash returns from your investments or to rely upon it to otherwise supplement your income, understanding the cash on cash return is a useful indicative tool.
Weaknesses of the Cash on Cash Return Calculation
The biggest weakness of the cash on cash return is also one of its biggest strengths. The cash on cash return calculation is very simple. While that means it’s relatively easy to calculate, it also means that the information it provides is limited. For example, the cash on cash return calculation doesn’t consider exposure levels to debt, tax implications or property appreciation.
Although the cash on cash return calculation may provide an overview and general indication of a property’s potential return, it shouldn’t be the only analysis that you use when making an investment decision. Further, the cash on cash metric does not account for resale, future cash flow, or the amount of debt on a property relative to its value.
Another weakness of the cash on cash return calculation is that it does not account for the time value of money or compound interest. This limitation only allows the calculation to provide insight into a snapshot of a building’s financial performance at a given moment in time, separate from other economic factors.
Cash on Cash Return vs. Return on Investment
The primary difference between the cash on cash return metric and the return on investment (ROI) is that cash on cash looks at ongoing ‘current’ income relative to total amount invested at a given moment in time, whereas ROI considers the total return once a property has completed its entire lifecycle and profits from sale have also been factored in to the equation.
The ROI looks at the entire cost of the investment and measures how much money is made overall and is then measured against the time value of money (this is where it gets more technical) to result in an internal rate of return (IRR) calculation. The ROI measures the overall return on an investment and illustrates the performance once a project has completed its lifecycle.
The ROI can take two forms; it can either be measured as an overall gross number relative to the original investment as a multiple of that investment, called the equity multiple, or it can be measured as an annual return, most commonly the IRR.
So, while the cash on cash return equation provides a limited picture of returns at any one moment in time, the ROI, no matter how calculated, generally refers to the overall returns on an investment and, consequently, represents a more complete picture of how that investment performed.
Both the ROI and cash on cash return are useful equations that benefit an investor, provided the distinction and nuances that come with each are fully understood.
How can you utilize leverage to increase your Cash on Cash Return?
There are two primary forms of capital investors use to acquire real estate: debt and equity. The equity piece is that which comes from the investor’s pocket. Cash-on-cash only applies to this type of capital. However, by utilizing leverage, another term for ‘debt,’ the cash on cash returns on equity can be increased.
Let’s look at two extreme examples.
Let’s say a developer buys a property for $10 million that has $500,000 per year net operating income, and that developer buys the property all-cash, using no debt. In this case, the cash on cash return would be $500,000 divided by the investment, $10MM, or 5% cash on cash.
On the flip side, let’s assume that the developer borrows 100% of the capital at 0% interest (just for the purpose of this example), then they would have no equity in the deal, yet would still be earning $500,000 in income. In this case, the cash on cash return would be infinitely large because there is no equity or no cash investment.
Picking the middle ground, to illustrate how leverage impacts cash on cash returns, let’s assume that the developer borrows $5 million from the bank at 4% interest. Now, the developer has debt service of $200,000 per year, netting him $300,000 in cash flow, but now only has $5 million in cash equity in the deal. His cash on cash return is now $300,000 on $5 million of invested capital, or 6%, rather than 5% if he had not taken on any leverage.
Leverage, when used wisely, can have a strong positive impact on increasing the cash on cash return but it does not come without risk. The higher the debt, the higher the risk that, if NOI drops for any reason to a point where it cannot service the debt payments, the owner may lose the property to the bank. A fine line is, therefore, important in balancing leverage in search of higher cash on cash returns.
What kind of goal should you set up for your rental property?
Each real estate investment is different. There are factors unique to your property, location, real estate market, local housing prices, employment rates, and interest rates. As an investor, you need to look at your priorities. Do you want to invest in multiple smaller real estate properties or focus on improving a single, larger property?
An investment strategy is also key to setting goals. An investor may prefer to build from the ground up a brand-new building, buy a mismanaged value add property, or invest in Class A properties with no vacancies and that have tenants with high incomes paying market rents.
Your goals should match the extent to which you are prepared to take on risk and, as importantly, the extent to which you want to be actively involved in the day-to-day management of an investment. Fortunately, these days you have the option to invest directly and handle the oversight and management yourself or invest as a partner with a professional real estate sponsor who does all the work for you for a participation in the profits. Either way, balancing your personal life with your work life and taking advice from your financial advisor or accountant are all important in determining the goals you set up to invest in rental properties.
Understanding your real estate investment is a vital part of success in the industry. There are many tools you can use to ensure you have all the information you need.
The cash on cash return is a helpful tool that can provide insightful information. The analysis is a great way to get a quick snapshot of returns on investment. This number can be helpful when you need to communicate with shareholders or a partner. It’s also a great way to see how much operational costs are cutting into your returns.
Think of the cash on cash return like a bathroom scale. The numbers will tell you whether you’ve gained a few pounds or lost weight, but it won’t tell you whether that weight is muscle or fat or identify outlying behaviors that could affect that number. The cash-on-cash return will give you a number that indicates your ongoing income stream, but it won’t tell you how much you are making overall or give you an indication as to the amount of risk you are taking.
For maximum benefit, make sure you’re considering other metrics like the internal rate of return, loan to value ratio, capitalization rates, and other metrics, and be sure to work with competent professionals no matter what you do. Contact us at Trion to find out more about our commercial real estate portfolio.