Cash on cash (CoC) provides an easy way for real estate investors to compare the profitability of similar income-producing similarities or gauge it against another investment opportunity quickly.
CoC, however, is not a particularly powerful tool for measuring the profitability of rental income character and currently gets less attention in real estate investment examination than it used to receive some years ago.
One shortcoming lies in the fact that cash on cash return does not take into account time value of money. Cash-on-cash return must be restricted to simply measuring a residential income character’s first year cash flow and not its future year’s cash flows.
Nonetheless, cash on cash is not without validity and nevertheless offers seasoned and beginning real estate investors a assistance that has always credited to its popularity.
CoC return measures the ratio between expected first-year cash flow to the amount of initial cash investment made by the real estate investor to buy the rental character. Hence, CoC is always expressed as a percentage.
The “first-year cash flow” (or annual cash flow) is the amount of money the character is expected to generate during the first year of operation. The “initial investment” (cash invested; sometimes called cost of acquisition) is the total amount of cash invested including down payment, loan points, escrow and title fees, appraisal, and inspection costs.
Okay, let’s start with an example and then make the calculation.
Suppose you are interested in purchasing a character with six units that each pays $1,000 per month rent. You calculate the first year’s operating expenses to be $28,800. You are planning on a new mortgage with $126,000 down payment, loan points of $2,940, and a monthly payment of $1,956. You calculate that your closing costs (escrow, title, inspections, and appraisal fees) will be $2,100.
Formula: Annual CashFlow / Cash Investment = Cash on Cash Return
In this case, you would need to make five calculations (to determine Annual CashFlow and Cash Investment) before you can compute for cash on cash.
- Annual Rental Income: (6 units x $1,000) x 12 = $72,000
- Net Operating Income (NOI; income less expenses): $72,000 – 28,800 = $43,200
- Annual Debt Service (mortgage payment): $1,956 x 12 = $23,472
- Annual CashFlow (net operating income less payment): $43,200 – 23,472 = $19,728
- Cash Investment (down payment + points+ closing costs): $126,000 + 2,940 + 2,100 = $131,040
Calculation: (Annual CashFlow / Cash Investment = Cash on Cash Return) $19,728 / $131,040 = 15.06%
Now that you know this specific investment opportunity yields a 15.06% CoC return, you can compare it to similar similarities, or different investments such as a T-Bill rate, and decide whether or not to proceed with a buy.