May 6, 2016
By David Saba
Investing in real estate often requires a big step forward, a little luck, and highly calculated efforts. Purchasing an investment property and hoping it cash flows is generally not considered to be a forward-thinking strategy; in order to truly make sure your investment is a success, proper preparation and a great understanding of what it takes to calculate your return are vitally important. The cash on cash formula can be a valuable calculation for investors seeking to understand projected returns, providing insight into what you can expect to gain from your investment.
If you are considering a real estate investment, like owning and managing rental properties, understanding the cash on cash formula and what it means for you can help you better evaluate your options, providing a little clarity into whether or not an investment is worth your time and hard-earned money.
One of the most important concepts in investing is the estimated rate of return. Put simply, a rate of return is your estimated gain or loss in a given period. For example, if you purchase a stock and expect it to increase in value 10% over the course of the following 12 months, that 10% increase would be your rate of return. If the stock's value should drop instead, your rate of return will be a negative amount.
In real estate investing, a cash on cash return is one of the most common rate of return calculations used to determine whether a potential investment is worthwhile. By evaluating how much cash your investment is costing you versus how much you expect to make from it, you can take a more objective look at the validity of the properties you have under consideration.
The formula to calculate cash on cash returns is quite simple:
Cash on Cash Return = Annual Pre-Tax Income / Total Cash Investment
In essence, this formula seeks to compare your how your projected cash flow compares to the amount of money you wish to invest. If you purchase a property for $100,000 and put $10,000 down in the first year, your cash on cash return will divide the amount of income you make by this annual expenditure. Technically, this could be examined on a larger scale - for example, the total investment you anticipate versus projected income over the lifetime of an asset - but cash on cash returns are more often more useful on an annual basis.
Cash on cash return calculations are very good for helping you understand the financial value in your investment. If you expect to pay $50,000 for a property in the first year and make $51,000 back in income, your annual return will be $1,000, or 2%. If you expect to only make $20,000, your return will be -$30,000, or -60%.
Cash on cash returns may vary from year to year; this figure is not a fixed value. An investment will often change over time depending on market movement and individual factors, like property maintenance, local rental markets, and customer reviews. Continuing to monitor cash on cash returns over time can help you make long-term decisions, especially when it comes to selling or otherwise disposing of a property.
As with most things in finance and investing, there are always multiple ways to look at any given scenario. Capitalization rate, or cap rate, is an alternate methodology of calculating return rates on real estate investments, and is calculated by dividing net operating income by total price of the property. For example, if you purchase a property for $200,000 and the net annual operating income is $20,000, your cap rate on this investment is 10%.
Cap rate, however, does not take financing into account. The amount you pay entirely for a property is only part of the expenses related to owning property; unless you are lucky enough to find someone willing to provide a mortgage at a zero percent interest rate, this is not necessarily an accurate picture of the return on an investment.
So, let's say you've found a property you want. It costs $100,000, and you are hoping that with three months of tenants, you can make $7,000 each year. You are able to find a banker who is willing to provide you with a ten year mortgage at 6.5% interest for $5,000 down. At this rate, you will be paying $10,650 per year. However, in your first year, you paid a down payment, which makes your first year's expense $15,650.
Thus, to calculate your cash on cash return, you will divide $7,000 by $15,650. This is a return of -55.27%, or a loss of over half of your invested cash, indicating an investment that is not sustainable. However, if your anticipate pre-tax income was $20,000 instead, your return would be roughly 27%, thus indicating a potentially profitable property holding, at least in the short term.
Human error is arguably one of the biggest shortcomings of the cash on cash formula; being able to accurately project cash flow can be a challenge, especially for those new to managing rental properties. Some new investors tend to consider only best case scenarios rather than reality, leading to an inflated return that will not be able to keep up with true income. Cash on cash returns also ignore the time value of money, making this calculation most useful during the first year of ownership.
In addition, the cash on cash formula only takes into account pre-tax income, which can appear exceedingly optimistic in some markets. Tax regulations when applied to real estate can be complex, leading to lower post-tax returns than initially expected.
While not a perfect measure of potential success, the cash on cash return formula is often a strong analytical tool, providing a way to objectively evaluate an investment opportunity. There are many factors that go into considering residential real estate, but the benefits of your investment are a sizable part of what you should considering. Using the cash on cash returns formula can provide valuable insights, helping you to truly evaluate the pros and cons of your potential property investments.
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