Cash On Cash Return or ROI
Cash on cash return is essentially used in commercial real estate transactions to determine the cash earned when cash is contributed to invest in a property. In that regard, the name itself is quite self-explanatory.
Cash on cash is synonymous with the world of real estate. It is almost always used for realty. Other fields such as the stock exchange use a formula known as Return on Investment. Cash on cash shows the leverage an investor has when they use borrowed funds.
Investing in property is always a significant investment. When a lump sum is being transferred, the cash on cash formula is employed to analyze the pre-tax part of these investments.
The simplest definition of cash on cash is that it is a basic theoretical concept for investors. The cash they receive from financing a deal expressed as a percentage of the entire amount they invested, is the cash on cash return.
For instance, if a buyer wants to purchase real estate, he may put down 20% as a cash payment. In this case, cash on cash return will be measured by calculating the yearly return the financier makes from the property in relation to the 20% down payment they made earlier.
A formula is used to calculate cash on cash return for a property and we will look into it in detail.
The formula uses a pre-tax influx made by the investor and the pre-tax outflow paid by the investor. We can use hypothetical facts and figures to gain a better understanding of what the equation will be.
If a business proposition is of interest to an investor, they will make a contribution to the property. Assume for the sake of comprehension that the real estate does not provide monthly returns. If the value of the land is 1 million dollars, we can presume that the investor involved will makes a down payment of 10% which is a hundred thousand dollar and they borrow the remaining amount, which is 900,000 in this case.
Sundry expenses that are part and parcel of such deals include maintenance cost, which can be significant depending on the condition of the property. Other expenditure might include insurance fees.
However, that is not the end of the deal. Other costs will be incurred along the way before we can crunch all the numbers to determine the cash on cash return for the property.
Consider that time has passed since they made the investment and closed the deal. In that time period, the buyer has paid 25,000 in loan fees, which consists of 5 grand in principal repayments. The loan will be subject to interest, which will make up the other 80% or 20,000 dollars.
We can now speculate that the financier has a change of heart and decides to sell his property. In this scenario, the value of his real estate has appreciated in the one year that has passed and it is now worth 1.1 million dollars. This brings us to the calculation of his cash on cash return.
His total cash input was 135,000 if we combine those 100,000 dollars they paid for the purchase, 10,000 dollars in miscellaneous expenses and 25,000 dollars in total as loan payment. Furthermore, they will have a debt of 895,000 dollars (900,000 is the borrowed amount, with the 5,000 paid in principal repayment of the loan).
1.1 million Minus 895,000 is tantamount to 205,000 dollars which the investor has at his disposal. The final step left to conclude the cash on cash return is to deduct his total cash outflow (135,000 dollars) from his inflow of 205,000 dollars and segregate the amount by his total investment which is 135,000.
The total of 205000 less 135000 divided by 135000 will give him almost 52%, which is his cash on cash return.
Although the terminology may change, the essence of the cash on cash return formula remains constant. For example, two different ways to interpret the data are given below:
- Cash on cash return = net operating income / total cash investment
- Cash on cash return = net cash flow after expenses / total cash invested.
To further grasp the concept of cash on cash returns, we can look at slightly different examples.
We can examine a case where no loan is involved. This will certainly have an impact on our calculation. A buyer will invest his money in a property which will cost him 250,000 dollars. Since there the notion of getting a loan is not included, they will arrange and pay the complete amount in a cash transaction.
Like we mentioned earlier as well, buying real estate involves accompanying overheads like repair costs. It is imperative to factor in random expenses which may be unforeseen but certainly come up when you buy a property. This naturally improves the quality of the estate.
Assume that the buyer in question pays 3% of the total cost in assorted expenses. 3% of 250,000 are equal to 7,500. Adding these two numbers will give the buyer 257,500 dollars, which is his total cash contribution.
The next logical step is to charge rent. We can assume that the rent is 2,000 dollars a month or 24,000 annually. Furthermore, another assumption we have to make to deduce the cash on cash return are operating expenses. We can assume that this cost is a third of the rent they earn, which means a third of 24,000 dollars is 8,000, which leaves the investor with 16,000.
Finally, return on the cash investment can be calculated using these numbers. The net operating income, which is 16000, will be divided by the total cash contribution which is 257500. 16000 divided by 257000 equals 0.062 which means the cash on cash return is 6.2% for the rental property.
The caveat we have placed on the following condition is that the customer needs a loan to finance the transaction, which is the most likely scenario since paying in excess of two hundred thousand dollars, let alone in cash, is virtually impossible unless you are a business tycoon or enjoy millionaire status. The average person will have to use banking services to initiate the deal.
Another obvious determinant to consider is that the calculation process can be intricate. For example, a layman will have to grasp the concepts before he can understand the idea behind cash on cash return.
Hence, we can use another set of speculative numbers to forecast the buyer’s cash on cash return. In a more realistic scenario, assume that the investor has availed a loan from the bank. We can use the same figures we used previously.
The value of the real estate is 250,000 dollars and the buyer decides to pay a fourth in down payment. Therefore, one fourth of 250,000 is 62,500. Add sundry expenses like maintenance costs to the equation, let’s say 7,500 dollars like we mentioned earlier and you end up with 62500 plus 7500 which is precisely 70,000.
The next step in the process is to figure out the net operating income (NOI). Over here we have to compute the debt service as well. Let us assume that a 5% interest loan yield is 5% of 180000 (250000 less 70000) which is 9000.
Therefore, the net operating income is 16000 subtracted by 9000 which equals 7000. The cash on cash return will be 7000 divided by 70000. The end result will be 10%.
Now that we have delved deeply into the concept of cash on cash return, we know what it entails. We have also elaborated with examples. The next step is to ascertain the limitations of this formula.
A fundamental flaw of the cash on cash return model is that it does not include the tax situation of the investor. Although users can amend the equation and come up with an after-tax number, the general formula does not account for taxation. This is a major issue since real estate is generally subject to a hefty amount of tax.
Short time span
Another shortcoming of the blueprint is that it only factors in a year, generally the first year, of investment. This is an issue since payments are skewed in the first year of investment owing to miscellaneous costs and agency fees.
These costs are not incurred on a yearly basis. For a more accurate calculation, it must be conducted over a number of years.
In conventional cases, the initial cost is not the true cost of acquiring property. This is important since costs like property taxes and capital investments are a foregone conclusion each and every time. The formula does not factor in these expenses. The final estimate does not factor in other statistics like compound interest.
True measure of worth
The formula does not recognize factors like appreciation or depreciation. Appreciation is defined as the upward adjustment in the value of an asset. Conversely, depreciation is an accounting method of assessing the gradual decline in a tangible asset’s value.
The general principle applied to most assets is that their value diminishes over time, which means they will depreciate with the passage of time.
Cash on cash return is a simpler measure when compared to other methods like Return on Investment (ROI).
We can also examine the importance of this analysis. It is important to know whether you are making a worthwhile investment. Buying real estate is particularly costly which is why it is mandatory to know whether you are making a smart decision.
Besides deriving the current expected return, it can also be used to forecast potential cash distributions of your investment. This is useful because buyers can set targets to assess an investment. It can also help them plan for the long term.
The ideal cash on cash return varies depending on who you ask really. While some experts consider 8% and beyond a good measure of success, other investors aim for at least 20% return on their investment.
The return is also contingent on the type of property. The return from a commercial estate may differ from that of residential realty. Some investors have a higher risk threshold which is why they seek greater returns when they invest cash in a property. More cautious buyers expect lower returns.
The general perception, although not proven, is that higher investment is directly proportional to higher risk. The conclusion when trying to surmise what a good cash on cash return is that it varies from one investor to another.
Cash on cash return, which is also called equity dividend rate, is a relatively straightforward metric for deducing the return when you are investing in property.
It is imperative to have an objective when investing a significant amount. The preferred approach is to set high goals and cash on cash return formula can help investors in doing just that. A simplistic method, cash on cash return can be used to understand how much cash flow might be thrown off when the property is in operation.
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