Cash-on-cash returns: Explained

If you’re looking to buy an investment property, a key metric you’ll likely focus on is whether you can make money from the rental or flip. Cash-on-cash return is a common metric investors use to calculate their anticipated returns on a property.

Calculating cash-on-cash return involves straightforward division: A / B = cash-on-cash return. You can also improve the reliability of your cash-on-cash return estimate by combining it with other investment metrics.

What is cash-on-cash return?

Cash-on-cash return is a formula that calculates how much cash you’re earning versus how much cash you invested in commercial real estate and rental properties. To calculate it, you’ll divide your annual property earnings before taxes from your initial cash investment in the property.

Here’s what the basic cash-on-cash return formula looks like:

Annual Pretax Cash Flow / Total Cash Invested In The Property = Cash-On-Cash Return

Annual pretax cash flow is the income a property generates before taxes. Suppose you rent out a property for $1,500 a month. At the end of 12 months, your pretax cash flow would total $18,000 ($1,500 ? 12).

The total cash invested in the property is just what it sounds like. It’s the total initial cash amount you invested in the property.

Calculate cash-on-cash return

Suppose you bought a property for $300,000 in an all-cash deal. That means your total initial investment is $300,000.

After accounting for expenses, you earn $3,000 a month renting out the property. That will add up to an annual pretax flow of $36,000 ($3,000 ? 12 = $36,000).

Use the annual pretax cash flow / total cash invested formula to estimate your annual cash-on-cash return.

$36,000 / $300,000 = 0.12, or 12% annual cash-on-cash return

To keep things simple, we’ve used a streamlined example that doesn’t get into calculating and subtracting property-related expenses from your total (or gross) income. We discuss how to calculate and subtract debts and expenses in a later section – but this is the heart of the math.

How cash-on-cash returns are used

Cash-on-cash return is a crucial calculation investors can use to quickly determine whether an investment property is worth their investment dollars. While the concept is simple, it will help you swiftly estimate the amount you need to spend on a property to meet your profitability goals.

You can place your profits into other investments or use them for maintenance and repairs on existing properties.

However, to get a more comprehensive measure of a property’s profit potential, consider combining cash-on-cash return with other key investment metrics, such as return on investment (ROI) and capitalization rate (cap rate).

Cash-on-cash return vs. ROI

Cash-on-cash return and return on investment (ROI) are both metrics that calculate the potential return on your real estate investment. However, investors primarily use ROI to compare one property to another.

Investors can also use ROI to estimate the total or cumulative profit they’ll make from owning a real estate investment property over time, including its potential sale price.

Cash-on-cash return vs. cap rate

The capitalization rate (or cap rate) is another popular metric you’ll see in real estate investing. Like ROI, cap rates can help investors compare properties by estimating how much profit a property can yield.

Unlike cash-on-cash return, cap rate doesn’t account for financing – like mortgage payments, so if you purchase a house with cash and have no debt service obligation, your cap rate and cash-on-cash return estimates will be the same.

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

To get a better idea of your actual net profit, here are some costs you’ll likely cover as a property owner and must subtract from your annual net cash flow.

• Mortgage payment: A monthly mortgage payment will factor into your annual pretax cash flow calculation, reducing your overall cash flow. A mortgage payment is typically made up of four components, including property taxes and homeowners insurance.
• Property taxes: You’ll pay local property taxes on the rental home. Property taxes cover public services, like police and fire protection, sewer access and garbage pickup.
• Homeowners insurance: You’ll pay for homeowners insurance if you have a mortgage on the property. Even if you don’t, buying a policy can be a good idea because it ensures coverage of any repairs on the property after damage or destruction. You’ll pay a slightly higher policy rate for a rental property because there’s more risk associated since you won’t be the one occupying the property.
• Maintenance fees: You may need to spend your own money on routine maintenance fees and home repairs. Investors with many properties or who live out of state often pay a management company to maintain and check in on their rental homes.
• Upgrades: If you make any upgrades to the property, like adding new appliances or investing in a total renovation, you should deduct the expenses from your annual property income when calculating your cash-on-cash return.

Cash-On-Cash Return Formula With Expenses

Let’s revisit our previous example of you making $36,000 a year in rent. The simplest way to account for expenses is to subtract your total expenses from your annual pretax cash flow.

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.

Suppose you spend $6,000 in annual expenses and $24,000 in mortgage payments. That’s $30,000 in total expenses. When you subtract $30,000 from your $36,000 annual income, your net income is $6,000.

When you make a mortgage payment, your total cash invested equals your down payment plus closing costs. If you put $50,000 down and pay $10,000 in closing costs, your total cash investment will equal $60,000.

Your remaining annual pretax cash flow of $6,000 is then divided by $60,000 (your initial cash investment), equaling 0.1, or 10%.

While you can estimate a property’s cash-on-cash return on your own, some real estate investors will work with a finance professional to figure out their cash-on-cash return to help ensure they don’t miscalculate any variables, such as their expenses or how much they're taking in every month.

What’s a good cash-on-cash return?

The current market conditions where you purchased your investment property will significantly influence your odds of generating a good cash-on-cash return. Think of cash-on-cash return as a snapshot. A good return in New York may not look the same as a good return in Chicago.

The overall health of the economy and real estate industry can also influence your ability to generate a good cash-on-cash return. The types of properties you’re buying and how much time, effort and funds you need to put into maintenance and renovations can also affect your cash-on-cash return.

Keeping up with your cash-on-cash return

While it’s not something you need to track each month, you can benefit from keeping an eye on your cash-on-cash return over time. Your cash-on-cash return can increase with higher rents or a high-priced property sale. It can also decrease if your expenses balloon or your property stays vacant for a few months while you look for new tenants.

You should anticipate a certain amount of fluctuation in your return based on what’s happening in the real estate market. Your fortunes may rise or fall based on shifts in the broader or local real estate market.

The bottom line

Cash-on-cash return is a simple, effective way to gauge the profit potential of an investment property. To calculate it, you’ll divide two key numbers: your gross annual property income from your initial cash investment.

This streamlined estimate should give a well-informed idea of whether you’ll make a good or bad return on investment. Are you ready to purchase a rental property? Start your mortgage application online with Rocket Mortgage^®.