Cash-On-Cash Return: What Is It And How Is It Used?
Victoria Araj7-minute read
September 27, 2023
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 potential reward (or lack thereof) from an investment – and one of these ways is cash-on-cash return.
Let’s explore what cash-on-cash return is, how and why it’s used and how you can calculate it. Then, we’ll walk through 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 calculates the potential return on investment (ROI) for commercial real estate and rental properties. It takes a look at your annual property-based income before taxes and compares it to the total cash you’ve invested in the property.
We’ll get into specific variables a bit later on, but the basic cash-on-cash return formula is:
Cash-On-Cash Return = Annual Pre-Tax Cash Flow ÷ Total Cash Invested 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 make other potential investments. You could also use the operating income from a given rental property to fund a down payment on future real estate investments.
Cash-On-Cash Return Vs. ROI
Cash-on-cash return and return on investment (ROI) are both metrics that are used to calculate the potential return on your real estate investment. However, they aren’t one and the same. ROI is primarily used to determine whether a real estate investor should purchase one property over another. ROI is also used to calculate the cumulative profit from owning a real estate investment property, including the potential sale price of the property in the future.
When considering the ROI of a rental property, you’ll use the following formula:
ROI = (Annual Rental Income − Annual Operating Costs) ÷ Mortgage Value
On the flipside, cash-on-cash returns measure your return on investment during a specific period of time (or your annual return on investment).
Cash-On-Cash Return Vs. Cap Rate
Cash-on-cash return and capitalization rate (or cap rate) are also two different metrics you’ll see in real estate investing. Like ROI, cap rate helps investors compare different properties to understand how much money the investment will yield.
Here’s the formula for calculating the cap rate on a real estate investment:
Cap Rate = Net Operating Income (NOI) ÷ Current Market Value
Unlike a cash-on-cash return, cap rate doesn’t account for financing – like mortgage payments. However, if you bought a house in cash, or there was no debt service obligation, your cap rate and your cash-on-cash return metrics would be the same.
Cash-On-Cash Return Example
Using an example, let’s take a look at how to calculate cash-on-cash return. Let’s say you bought a property for $300,000 in an all-cash deal and you charge $3,000 per month when you rent out the property. That means you’re making $36,000 on the rent for the year.
Your cash-on-cash return is 12% back per year ($36,000 ÷ $300,000 = 0.12).
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 (maybe home maintenance or repairs).
How Does A Cash-On-Cash Return Work With A Mortgage?
Keep in mind that you’ll want to include any debt related to the property in the cash-on-cash return calculation. So, if you took out a mortgage loan to finance the home purchase, you’ll subtract your annual mortgage payments from your annual cash flow. Only items like your down payment and closing costs are counted toward your initial investment.
In the example above, let’s say you made a $50,000 down payment instead of an all-cash offer. Now assume you had to pay about $10,000 in closing costs. If your monthly mortgage payment is $2,000, your mortgage payments for the year amount to $24,000.
To calculate your cash-on-cash return, you would subtract $24,000 from your estimated annual pre-tax cash flow (the $36,000 in annual rent payments). Then, you would divide this number by your initial investment costs (the $50,000 down payment and the $10,000 closing costs).
$36,000 − $24,000 = $12,000
$12,000 ÷ $60,000 = 0.2
Your cash-on-cash return would be about 20%. Keep in mind that this calculation only takes into account your down payment, closing costs, mortgage payments and annual rental income. We’ll discuss other expenses you may want to consider when calculating your cash-on-cash return below.
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What Expenses To Consider In A Cash-On-Cash Return Formula
In addition to potential mortgage payments, other operating expenses come with owning an investment property. Here are some costs you’ll likely have to cover as a property owner that can be subtracted from your annual net cash flow. This can help give you a better idea of your actual net profit from a cash-on-cash return formula.
- Property taxes: You’ll have to pay local property taxes on the rental home. Property taxes cover items like city services for police and fire protection, 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 can be a good idea because it ensures the property will be repaired if damaged. Keep in mind that you’ll pay a slightly higher rate for a rental. There’s more risk associated with the policy if you’re not the one occupying the property.
- Maintenance fees: You might have to spend out-of-pocket for routine maintenance fees and home repairs. If you have many properties or live out of state, you may pay a service to maintain and check in on the rental homes 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.
Cash-On-Cash Return Formula With Added Expenses
Let’s revisit the example above, where you’re making $36,000 annually in rent. The simplest way to account for these additional expenses is to subtract the total amount of the expenses from your annual pre-tax cash flow (or the numerator) in the cash-on-cash equation.
If you have $6,000 in annual expenses plus $24,000 in mortgage payments, you have $30,000 in total expenses. If you subtract that from the $36,000 in income you’ve earned, your net income is $6,000, which is then divided by $60,000 (initial investment) equaling .1 or 10%.
Some real estate investors may consider working with a financial professional to figure out their cash-on-cash return. However, the cash-on-cash return calculation is something 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 dictated by the current market conditions in the area where you purchased your investment property. Think of a cash-on-cash return more as a snapshot. A good return in New York might not be the same as a good return in Chicago.
A good cash-on-cash return can also be determined by the state of the economy and the real estate industry at the time. The types of properties you’re buying and how much effort (and funds) you need to put into maintenance and renovations can also affect your cash-on-cash return.
Cash-On-Cash Returns In Real Estate
When the real estate industry is in a hot seller’s market, it means there are more home buyers than properties for sale (in other words, property inventory is limited). In this kind of market, overpaying on a house – whether it’s because of a bidding war or from a moment of excitement – could mean the difference between making money in real estate and a lost investment.
Real estate investors may calculate cash-on-cash return slightly differently depending on what they choose to include in the formula. Having a profitability margin in mind and using the cash-on-cash equation to help determine a good price on the home might be crucial for your home purchase.
Using Your Cash-On-Cash Return As A Down Payment
If you achieve a consistent cash-on-cash return, you can use the profits to buy more investment properties. For example, you could use the extra money to fund a down payment on a future rental house. If you want to take this route, you must have 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 track every month, it’s a good idea to have an eye on your cash-on-cash return over time. Your cash-on-cash return can go up with increased rents or a high property sale on a flip. It can also go down if you have increased expenses or a few months without renters because you’re looking for 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, but that’s totally normal.
The Bottom Line: Calculate Your Cash-On-Cash Return
Cash-on-cash returns are a simplified method of calculating the potential ROI for investment properties. They involve taking your gross annual income from the property and dividing it into your initial real estate investment.
In calculating a cash-on-cash return, we hope you get a feel for what might be a good or bad return on investment. Are you ready to purchase a rental property? Start your mortgage application online with Rocket Mortgage®.
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