In this particular real estate investing article, we want to discuss cash-on-cash return by exploring its which means, benefits and shortcomings, popularity among real estate investors, and then the cash-on-cash formula alongside several examples.
So let’s get started.
The cash-on-cash return (or equity dividend rate) procedures the ratio between a property’s anticipated first year’s cash flow just before tax (CFBT) to the amount of preliminary cash investment made by the real estate buyer to purchase the rental property.
Here’s the idea: cash on cash could be the percentage of cash flow to money investment.
The popularity and use of cash-on-cash in real estate investing is because it provides traders with an easy way to compare the profitability of several investment possibilities quickly. For example , an investor could compare the first-year yield of a real estate investment based on its cash-on-cash (or CoC) to the yield offered by a bank on a CD. In this case, for instance, the investor might decide to commit his cash into an apartment complex that returns a CoC of 7. 6% rather than into a COMPACT DISC paying 3%, and vice versa.
Generally speaking, though, cash-on-cash return is not really considered a particularly powerful tool for measuring an income property’s profitability since it doesn’t consider the time value of money. In other words, because it doesn’t compound or even discount money over time, CoC is restricted to measuring an investment property’s income in the first year of possession only.
Nonetheless, the cash-on-cash come back is not without validity. It certainly will provide real estate investors a quick way to compare investment opportunities and similar income-producing properties.
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How to Calculate
Money on Cash Return = Yearly Cash Flow / Cash Investment
What It Means
Before we consider an example, let’s be sure we understand the components of the formula. This will be crucial for you to compute cash-on-cash correctly in your own rental house analysis.
1) Annual Cash Flow — This is the cash flow before tax (CFBT) in opposition to the cash flow after taxes (CFAT). In other words, it’s the cash flow for the first-year without an adjustment for Federal income tax. CFBT is calculated simply by computing annual rental income much less annual operating expense less yearly debt service or loan transaction.
2) Cash Investment – This is the total amount of initial cash necessary to purchase the property and includes the down payment, loan points, escrow plus title fees, appraisal, and examination costs.
Okay, let’s figure out a cash-on-cash return.
You’re examining the profitability of a six-unit house building according to the following scenario. Each one of the six units collects $1, 000 per month. You estimate the first year’s operating expenses will be $28, 800. Your mortgage requires $126, 500 down, loan points of $2, 940, and a monthly loan payment of $1, 956. You calculate your closing costs, i. e., escrow, title, inspections, and evaluation fees, at $2, 100.
1st, compute the annual cash flow:
Gross Scheduled Income $72, 000 ((6 units x $1, 000) x 12)) less Operating Expenses of $28, 800 equals $43, 200 (Net Operating Income) less Home loan Payment $23, 472 ($1, 956 x 12) = $19, 728 Cash Flow
Next, compute your cash investment:
Down Payment of $126, 000 in addition Loan Points of $2, 940 plus Closing Costs of $2, 100 = $131, 040 Cash Investment
Finally, compute CoC:
Cash on Cash Return = Annual Cash Flow / Cash Investment, or even, $19, 728 / $131, 040 = 15. 06%
Okay, now let’s apply it.
You’re trying to choose where to invest $126, 000 cash. You can invest it in a 3% T-Bill at your local bank or, as you just discovered, you can purchase a six-unit rental income property and obtain a cash-on-cash return of 15. 06%. What do you do next? You might want to do a full-blown real estate analysis on the property and look at some other key returns and measures. Though on the surface, the particular investment real estate appears to be the most prudent real estate investing choice, you can’t make a decision without more information and a more complete real estate property analysis.
But here’s the caveat. Be sure to use credible property information for your analysis; confirm that everything the seller or agent gives to you can be complete and accurate; compute almost all numbers and property data concisely and carefully.