Cash-on-cash returns: A guide for real estate investors

Interested in buying an investment property? You'll want to earn a profit whether you’re buying a property to rent or to improve and flip. One metric that you can use to help determine whether you'll make money from your real estate investment is cash-on-cash return.

To calculate the cash-on-cash return, you'll need to know how much rent the property can earn each month and the total cash you expect to spend on acquiring it and renovating it.

We’ll explain how the formula can benefit investors.

What is cash-on-cash return?

You can calculate an investment property’s estimated cash-on-cash return with this simple formula:

Annual pretax cash flow ÷ The total amount of cash you invest in the property = A property’s cash-on-cash return.

A property’s pretax cash flow is the amount of money it earns before taxes and after you eliminate expenses. If you estimate that you can rent out a property for $3,000 a month and you had no other expenses, that property’s annual pretax cash flow would be $36,000, or $3,000 a month times 12. That is a simplistic example. Most investors will have some expenses, such as a mortgage payment or maintenance costs, to deduct from the monthly rent their properties generate.

Total cash invested in the property is the amount of money you estimate spending to purchase the investment property. If you’re buying with cash, you can simply plug in the amount you’re spending. For a home costing $300,000, your total cash invested would be that same $300,000.

This changes if you’re using a mortgage to finance the property. In this case, your total cash investment will be the total of your closing costs and down payment. Your monthly mortgage payment won’t show up on this side of the equation but will lower your annual pretax cash flow.

If you plan to renovate a home and then flip it, you’ll need to include any up-front renovation costs to the property as part of your total cash invested. If you spend $300,000 in cash to purchase the home and $20,000 more to gut-renovate that property’s kitchen and bathrooms, your total cash invested will be $320,000.

How to calculate cash-on-cash return

Here’s how to calculate a property’s potential cash-on-cash return using the numbers above:

Let’s say you expect to rent out your investment property for $3,000 a month, which comes out to $36,000 a year. Let’s say, too, that your total cash investment is $320,000, a combination of up-front renovations and your all-cash purchase of the property.

Using the cash-on-cash formula, you’d divide $36,000 by $320,000 to get 0.1125. If you multiply that by 100 to get a percentage, you’d come up with a cash-on-cash return of about 11%.

How cash-on-cash returns are used

It takes a significant amount of cash or debt to invest in real estate. That’s why it’s so important to at least get a rough estimate of how much you can earn from your investment properties. That’s where cash-on-cash returns can help.

This formula can help you quickly determine how profitable an investment property might be. Many investors reinvest their profits in additional properties or use these profits for maintaining their investments. Knowing how much profit an investment property might earn, then, is essential.

What expenses to consider with the cash-on-cash return formula

You’ll face plenty of expenses when investing in real estate. To get a more accurate calculation of your cash-on-cash return, you’ll need to subtract these expenses from your annual pretax cash flow.

Here are some of the most common expenses real estate investors face:

Mortgage payment: If you’re financing the purchase of an investment property, you’ll make a mortgage payment each month that you need to factor into your expenses. How much that payment is depends on the amount you are borrowing, the term of your mortgage, the size of your down payment, and your interest rate. The lower your rate and term, the smaller your monthly payment.

Property taxes: You’ll also need to pay property taxes, which will vary depending on the location of the home that you are buying. You’ll usually have to pay a portion of your estimated yearly property taxes with each mortgage payment. Your lender will collect these payments in an escrow account and use them to pay your property tax bill on your behalf.

Homeowners insurance: If you take out a mortgage, your lender will require that you also take out a homeowners insurance policy. You’ll also pay a portion of your yearly insurance premium with each mortgage payment.

Maintenance costs: You’ll need to spend money on maintaining your investment properties. How much you’ll spend each year on this varies, but insurance provider State Farm says that you should expect to pay 1% – 4% of your home’s value on maintenance each year.

Cash-on-cash return formula with expenses

To come up with a more accurate cash-on-cash return, it's important to subtract any expenses associated with buying or maintaining your investment property from your annual pretax cash flow.

Here’s how you do this:

1. Add up your expenses, like mortgage payments and maintenance costs.
2. Subtract your expenses from your annual pretax cash flow.
3. Divide your remaining annual pretax cash flow by your total initial cash investment.

Here's an example: Say you again plan on renting out your investment property for $3,000 a month, equal to an initial pretax cash flow of $36,000. But say you also spend $24,000 in mortgage payments on your property each year and $6,000 in annual expenses that include the cost of maintaining your property and the money you spend each year on property taxes and homeowners insurance payments.

You'll need to subtract your total of $30,000 of yearly expenses from the $36,000 in rent you expect your property to generate. That will leave you with a pretax cash flow of $6,000.

When buying an investment property with a mortgage, your total cash investment to purchase the property will be the combination of your down payment plus closing costs. If you provided a down payment of $50,000 and you paid $10,000 in closing costs, your total cash investment will come to $60,000.

To calculate your cash-on-cash return, divide your pretax cash flow of $6,000 by your initial cash investment of $60,000. This will give you a cash-on-cash return of 10%.

What’s a good cash-on-cash return?

There is no one answer for what makes for a good cash-on-cash return when investing in real estate, but 8% – 12% is a general industry consensus. You’ll have to consider the average rental rates and sales prices in the markets in which you want to invest.

You’ll also need to consider the size of the property you want to purchase – larger properties might require more maintenance but also might generate higher rents – and the type of property. You might earn a higher cash-on-cash return when investing in a single-family home because of its lower maintenance and purchase costs than you would by investing in a warehouse building or retail strip center.

Caveats of cash-on-cash returns as a metric 

While cash-on-cash return is a useful metric for investors, it’s not perfect. There are some downsides to this way of measuring a property’s potential profit.

Leverage can make returns look better than they really are: When buying real estate, leverage is the money that investors borrow to help purchase a property, such as a mortgage. When you take out a mortgage to buy an investment property, you’re lowering your total up-front cash investment in the property. This lower up-front investment can make your returns look stronger even though you’ll spend more money overall when using a mortgage to purchase property.

They overlook the impact of rising property values: Another way to earn money on investment real estate is to hold it and then sell it after it increases in value. If you buy a single-family home for $150,000, hold it for several years and then sell it for $250,000, that extra money will boost your profit, something that the cash-on-cash return formula doesn’t account for.

They miss the value gained from paying down your mortgage: When you pay off your mortgage, you’ll build equity in your home, the difference between what you owe on your mortgage and what your home is worth. The more equity you have, the greater your profit when it’s time to sell. Again, the cash-on-cash return formula doesn’t include any benefits you might receive from building equity in an investment property.

They capture performance at just a single moment in time: Cash-on-cash return provides an immediate snapshot of a property’s potential income potential, but it doesn’t tell you what a property’s potential for profit might be in the future. Maybe you’re buying into a neighborhood that is on the verge of booming. You might have to charge a lower monthly rent for your property now. But in 2 years, you might be able to boost that rent significantly, increasing the property’s cash-on-cash return.

They leave out important tax perks that affect your bottom line: When you finance the purchase of an investment property, you can deduct the interest that you pay each year on your mortgage from the income taxes you pay. You’ll need to itemize your taxes to claim this deduction, but the savings could boost your property’s profitability, something that the cash-on-cash return formula doesn’t consider. You can also deduct at least a portion of the property taxes you pay.

They don’t account for the possibility of falling property values: Just as cash-on-cash returns don’t account for a gradual increase in your property’s value, it doesn’t account for the possibility that your real estate investment could lose value. Maybe you buy in a neighborhood in which real estate values begin to fall. If your investment’s value falls, you could lose money if you decide to or are forced to sell.

Cash-on-cash return vs. NOI  

Net operating income (NOI) is the cash flow that a real estate investment generates from its daily operations. It’s another metric that can help investors determine if a piece of real estate is generating enough profit.

To determine a property’s NOI, you’ll need to know the annual income it generates and the money you can expect to pay in operating expenses each year. Your property’s income includes the rent you’ll charge and other income streams such as parking fees or pet fees. Its operating expenses can include the cost of insurance, utilities, property taxes, management fees, and maintenance.

The formula for determining NOI is a simple one: (Gross operating income + other income) – operating expenses = NOI.

Keeping up with your cash-on-cash return

It’s important to recalculate your cash-on-cash return occasionally, especially if your operating expenses rise or you increase the monthly rent you are charging. Monitoring your cash-on-cash return can help you better track the performance of your real estate investment.

If you increase your property’s monthly rent, your returns might increase. On the negative side, if your operating expenses rise, your returns might fall.

The bottom line: Cash-on-cash return can help you make smart real estate investments 

Investing money in real estate can be risky. One way to lessen this risk is to calculate how much cash you can expect to make on your investment property. The cash-on-cash return formula can help you do this.

It helps to research the risks and rewards of real estate investments. You can start on this by visiting the Rocket Mortgage^® Learning Center, which includes information on home values and the potential returns you can earn from residential real estate.

If you’re ready to start investing in real estate and you need a mortgage to get started? Fill out our online application to begin working with Rocket Mortgage.