When you’re researching a commercial real estate property as a potential investment, there are many factors to consider. Cash on cash return tells you how much you’re making on a rental property after expenses on an annual basis. It’s a common metric commercial real estate professionals use to evaluate a CRE deal. This article explains how to calculate cash on cash return, how to determine a good rate and how this metric compares with cap rate and ROI.
The cash on cash return, sometimes called COC return, is the ratio of annual cash flow (before tax) to the total cash invested in the rental property. This number is expressed as a percent. Cash on cash return is a simple metric used to assess the cash flow relative to the overall cash invested in the property.
Calculating cash on cash return is easy if your accounting is in good shape. Here’s how it’s done.
Here is the formula for cash on cash return:
Cash on cash return = Annual cash flow (pre-tax) / total cash invested in the property
To calculate cash on cash return, you’ll need to add up your income and expenses. Your annual cash flow is the total amount of income you receive on the property. To calculate annual cash flow, you’ll subtract your total operating expenses from your total income, which comprises rent and any other forms of income you receive from the property (for parking space, for example). Operating expenses include costs like property management, any expenses for regular upkeep and your annual mortgage payment. To calculate the total cash invested in the property, you’ll add up all the expenses such as your down payment, closing costs, repairs, renovations and any other upfront expenses.
Let’s consider an example of how this might work. Let’s say an investor purchases a $2 million property and invests a total of $400,000 into the property. Each month this property makes a total of $15,000 in income from apartment rentals. However, let’s say operating expenses, which include the mortgage payments, add up to $12,000 per month. After expenses are paid, the investor will be making $36,000 per year ($180,000 – $144,000) before tax.
The cash-on-cash return would be:
($180,000 – $144,000) / $400,000 = .09 (x100) = 9%
While CRE professionals’ opinions vary on what makes a good cash on cash return, lower returns are generally associated with lower risk, while higher returns tend to come with increased risk. The higher the cash on cash return, the more money the investor is making proportional to their initial investment. Cash on cash return rates generally range anywhere from 2% to 12%, Walt Batansky, Chief Financial Officer of Avocat Group told lev.co. However, they tend to fall between 4% and 8%, he added. A good cash on cash return will depend on many factors, including the “quality of the property, the term of the lease and most especially the credit of the tenant,” Batansky said. For example, a property with a tenant like Amazon typically has a low return, because everyone wants Amazon as a tenant. On the other hand, a plumbing service with a mom and pop owner is a much riskier investment, and so an investor will likely want a higher cash on cash return.
Additionally, if there are only two years left on the lease and it’s unclear whether the tenant will renew, there’s much more risk. In a situation like this, “[Investors] might look at 10 or 12 cap rate, because they’re anticipating that they’re going to have vacancy and then once that tenant moves out, you have to go in and fix it up and remodel the offices and do repairs and all kinds of other things,” Batansky explained. On the other hand, if an investor believes a property will appreciate in value, he may not be as concerned with the rental property’s short-term income.
Financing will also influence your cash on cash return. “The more premium financing options the property qualifies for, the better cash-on-cash return. That is because the terms of the mortgage will include longer financing periods with lower interest rates versus properties that will have to be financed with sub-prime lenders such as bridge loans,” Tomas Sulichin, President of Commercial Division at RelatedISG Realty, told lev.co. “Generally, the more you leverage, the lower the return will be.”
Check out our interview with Tomas!
Cash on cash return and capitalization rate are two metrics used to determine the return on an investment property. “A cap rate measures the current return of an investment in comparison to the actual price of the property,” Sulichin said. If a property is worth one million dollars and brings a net yearly return of 80K yearly in return, the cap rate would be 8%.
The formula for cap rate is:
Cap rate = net operating income (NOI) / property’s market value or sales price
Batansky explained that “cap rate and cash on cash return are the exact same thing if you are paying all cash for a property.” However cash on cash return factors in financing. Cap rate is a metric that does not change depending on financing. This fact makes it easy to compare different properties based on cap rate. “When a property is listed for sale, the advertised cap rate will show a potential buyer how profitable a property could be from day one,” Sulichin said. On the other hand, cash on cash return is a metric each investor has to calculate based on their financing. “Cash on cash returns tell the investor how much profit they will receive for each dollar invested and are often used for investment properties that involve long-term debt borrowing,”
Sulichin said. “Investors might use both calculations to determine whether or not they found a good deal. If you are financing, your cash on cash return could be a little lower than the cap rate.” “If the buyer is financing the property, then a cash on cash return will vary, even slightly, because it will depend on the financing terms used to buy the property. One buyer can have a bigger cash on cash return than another. It will all vary according to the interest rate secured and how big of a down payment a buyer is able to put down,” Sulichin explained.
The return on investment, or ROI, is the annual profit plus profit made from appreciation when you sell the property. Let’s say, you buy the property for $1M today. You hold it for 10 years, and you sell it for $1.5 million. The return on investment is the total profit you make once you account for closing costs associated with selling. You’ll factor in your cash on cash return during all that time, plus the profits you made when you sold the property. “Typically, return on investment or ROI is the number that we’ll use if we do a projection,” Batansky said. “The return on investment includes the sale proceeds, whereas the cash on cash return is just the annual income, net income less debt service.”
The ideal cash on cash return on an investment will vary depending on whether the investment is more conservative or risky. While it’s common to see cap rate posted in listings of a property, cash on cash return will vary based on an investor’s financing (including their down payment and interest rates). While ROI reflects the total return of an investment, including income and appreciation, cash on cash return only tells you how much a property will make on an annual basis, and does not account for profit made from the potential appreciation of a property. It’s an important metric to determine how profitable a property is annually, relative to expenses.
