Cash-On-Cash Return: What Is It And How Is It Used?
Kevin Graham5-minute read
June 04, 2021
If you’re looking to buy an investment property, the most important metric is whether you can make money from the rental or the flip. There are various ways to calculate the anticipated reward or lack thereof from an investment, but today, we’re going to take a look at cash-on-cash return.
In this article, we’ll explore what cash-on-cash return is, how and why it’s used, and how you can calculate it yourself. We’ll close by discussing how to think about a good cash-on-cash return and how it can change over time.
What Is A Cash-On-Cash Return?
Cash-on-cash return is an equation that takes a look at your annual property-based income before taxes and compares it to the total cash you have invested in the property.
We’ll get into specific variables a bit later on, but the basic formula is:
Gross yearly income derived from investment property
Initial investment in the property
If you can consistently gain a higher return, you can use this formula to determine how quickly you might be able to use the funds from this property to fund a down payment on future real estate investments.
We’ll go deep a little later on, but for now let’s take a look at a simple example. Let’s say you bought a property for $300,000 in an all-cash deal. You charge $3,000 per month when you rent out the property. That means you’re making $36,000 on the rent. Your cash-on-cash return is 12% back per year ($36,000/$300,000).
How And Why Is A Cash-On-Cash Return Important?
Cash-on-cash return is important because it gives you a quick way to determine whether purchasing an investment property is worth it. It’s simplified, but it gives you an idea of the price at which you would need to purchase a property to meet your profitability goals. Those profits can then be plowed back into other investments or whatever you wish to use them for.
One important note to keep in mind when it comes to cash-on-cash return is that it doesn’t include debt related to the property, so if you have a mortgage, only your down payment and closing costs are counted towards your initial investment. In the example above, if you instead made a 25% down payment, your initial investment would be $60,000 and your cash-on-cash return would be 60% ($36,000/$60,000).
However, you could see that without adding annual mortgage payments back in, this number can be a little misleading and have its shortcomings. It’s not uncommon to add the mortgage payment they can for a fuller picture.
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Your Very Own Cash-On-Cash Return Formula
Setting aside the mortgage for the moment, there are expenses that come with owning any home, let alone using it to flip or rent out. Here are some expenses that should be backed out from your annual rent charges in order to get to your actual gross profit for the purpose of a cash-on-cash return formula:
- Property taxes: You’ll have to pay local property taxes. These cover things like city services for police and fire protection as well as sewer access and garbage pickup in many cases.
- Homeowners insurance: You’ll have to pay for homeowners insurance if you have a mortgage on the property. Even if you don’t, it’s always a good idea because it ensures the property can be repaired in the event of damage. One thing to be aware of is that you pay a slightly higher rate for a rental because there’s more risk associated with the policy if you’re not the one occupying the property.
- Maintenance fees: If you have many properties or live out of state, you may pay a service to maintain and check in on them for you.
- Upgrades: If you make any upgrades to the property like adding new appliances or even doing a full renovation, that should be deducted from your annual property income for the purposes of the cash-on-cash calculation.
The simplest way to do this is just to subtract your total expenses out of the numerator in the cash-on-cash equation. If you have $6,000 in annual expenses in the same initial investment of $60,000 for down payment and closing costs, your cash-on-cash return is now 50% ($30,000/$60,000).
Some people go to a professional to help them figure out their cash-on-cash return, but as you can see, this is something that you can pretty easily do yourself if you know your expenses and how much you’re taking in on a monthly basis.
What’s A Good Cash-On-Cash Return?
A good cash-on-cash return can be very much dictated by the moment in time in market conditions in the area. It’s a snapshot. A good return in New York might not be the same as a good return in Chicago.
It’s also about the state of the economy and real estate industry at the time, the types of properties you’re buying and how much effort you need to put into maintenance and renovations to gain that potential return.
Cash-On-Cash Returns In Real Estate
It’s also important to be careful. The real estate industry in general is seeing a hot seller’s market with limited supply. In this kind of market, overpaying in the excitement of the moment could mean the difference between making money in real estate and a bad deal.
Additionally, different investors calculate cash-on-cash return slightly differently depending on what they choose to include in the formula.
Because of this, having a profitability margin in mind and using the cash-on-cash equation to help determine what a good price on the home is might be crucial.
Using Your Cash-On-Cash Return As A Down Payment
If you achieve a consistent cash-on-cash return, you can use those profits to buy more property by using it as a down payment on a future rental house. If you want to do that, there has to be consistent cash flow over time to achieve that goal in a reasonable timeframe.
Keeping Up With Your Cash-On-Cash Return
While it’s not something you need to obsessively track every month, it’s a good idea to have an eye on your cash-on-cash return over time because it does change positively with increased rents or a high property sale on a flip. It can also go down if you have increased expenses or you have a few months without tenants because you need to find new ones.
A certain amount of fluctuation is dictated by the real estate market as well. Your fortunes may go up or down based on the broader market around you. That’s not abnormal.
The Bottom Line: Impact Of Cash-On-Cash Returns
Cash-on-cash returns are a simplified method of calculating the potential return for rental properties. It involves taking your gross annual income from the property and dividing it into your initial investment. It has some drawbacks in that it doesn’t take into account that like mortgage payments, but they can be added back in.