The cash-on-cash analysis is used by investors to calculate the return on a rental property. It compares your annual pre-tax cash flow against your total upfront initial investment. Your initial investment includes down payment, closing costs and any initial repair costs. The income generated by the property includes rental and other income minus expenses. Expenses include operating expenses such as taxes, insurance and maintenance as well as vacanies expenses. Expenses also include your monthly principal and interest costs, otherwise known as debt service.
Example using the cash on cash analysis
Let's say you find a fourplex you want to purchase for $400,000. Your lender requires a down payment of 25% ($100k). Closing costs and some upfront rehab costs amount to 5% of the purchase price ($20k) which brings your out of pocket investment to $120k. You will finance the remaining $300k at a rate of 4.7% over 30 years. Your rental income of $4,000 per month is the only income generated at the property. You estimate an annual 4% vacancy allowance and an annual operating expense of 28%.
The cashflow breakdown is as follows:
(gross rent income)
(gross operating income)
(net operating income)
Cash on cash return = cash flow ÷ investment
Cash on cash return is 11.64% (13,969 ÷ 120,000 = .1164 or 11.64%)
Remember, the cash on cash analysis measures the annual pre-tax cash flow against the actual cash investment. It does not factor in unseen returns such as appreciation, equity pay down, or tax benefits. You'll want to consider these things in your overall analysis before purchase but they are not a part of the cash on cash analysis.
CoC Return: Annual Net Operating Income / Total Cash Investment
Purchase price $: the amount you pay for the property.
Down payment %: the amount of the down payment measured as a percentage of the purchase price. Multi-family investment mortgages typically require 25% down.
Additional cash investment $: additional money out of your pocket at time of purchase. Think closing costs + pre-rental repairs or improvements.
Gross monthly income $: total rent income plus any other income generated by the property per month. Other income might include money generated from laundry and other vending machines or renting some storage space.
Vacancies allowance %: estimated percentage of the year that the property may be vacant. A typical estimate might be 4% (2 weeks).
Annual Operating expenses % (total annual expenses ÷ gross annual income): annual expenses such as property taxes, insurance and maintenance. The below defaults use a value of 28%. Example: 7000 (taxes) + 3500 (insurance) + 2940 (maintenance) = 13,440. Gross monthly rent 4000 x 12 (months) = $48,000 (gross annual income). 13,440 ÷ 48,000 = 28%. If you pay someone to manage the property, add that cost as an expense. Some formulas also factor in reserves for replacements (money set aside to replace short-lived items like appliances). Keep in mind, when comparing properties against one another, remember to include the same variables for each property.
Debt service $: debt service is calculated for you. It's the annual principal and interest portion of your loan. Taxes and insurance are not included as debt service as they are factored in as operating expenses.
Calculate the Cash on Cash Return
Questions? Call Donald J Hughes with United Realty Group at 954-649-0654.
Cap Rate vs. Cash on Cash
Cap Rate = Net Operating Income / Sales Price
Cash on Cash Return = Annual Pre-tax Cash Flow / Total Upfront Investment
If you purchase a property with all cash and with no additional investment costs, the Cash on Cash return will be the same as that of the Cap Rate. Conversely, if you purchase the property with a mortgage, the denominators will be different. For example, if you finance 75% of a $400,000 purchase with no additional cash investment at purchase, the denominator (investment) will be $100,000 as opposed to $400k for a cash purchase.
How does Cap Rate differ from Cash on Cash return?
Cap rates are primarily used to compare different investment opportunities when determining whether or not an investment is worthwhile. Some investors set a minimum cap rate percentage to accept when investing in a property. Keep in mind, there are other factors to consider when purchasing investment properties. For example, a 5 year old structure with a Cap Rate of 7% might be considered a better investment than a 40 year old structure with a Cap Rate of 8.5%. There is generally less costs for maintenance and repairs associated with a newer building, making it a less risky investment.
Cash on Cash return measures the relationship between cash invested and the cash flow, or the net operating income of a property. It measures the annual return on investment.
Purchase all Cash vs. with a Mortgage
You might think that purchasing investment property is best done with all cash. After all, the interest payments associated with a mortgage work to negate your profits. However, by leveraging the bank's money, you may actually be able to increase your cash flow.
Consider the following: Mr. and Mrs. Investor have their eyes on a $250,000 multi-family investment property. The property is a duplex that brings in $1,100 per month per unit for a total of $2,200 gross monthly income. Current interest rates are 4%. They figure 4% for vacancies allowance and 28% for annual operating expenses. They can purchase it all cash or they can use a mortgage which they are already pre-approved for.
Use the Cash on Cash calculator for the following purchases:
All cash: Mr. and Mrs. Investor purchase all cash (100% down payment): Cash on Cash return = 7.18% Cash flow = $17,952
Mortgage at 4% interest: Mr. and Mrs. Investor purchase using a mortgage at 4% interest with a 25% down payment: Cash on Cash return = 11.54% Cash flow = $7,210
Mortgage at 6% interest: Mr. and Mrs. Investor purchase using a mortgage at 6% interest with a 25% down payment: Cash on Cash return = 7.14% Cash flow = $4,462
Mortgage at 7% interest: Mr. and Mrs. Investor purchase using a mortgage at 7% interest with a 25% down payment: Cash on Cash return = 4.77% Cash flow = $2,983
While increased cash flow is a good thing, the Cash on Cash analysis allows us to see how we might improve our cash flow under different situations. For example, using the above scenarios, cash flow is at its greatest with the all cash investment. However, the CoC return is higher when purchasing with 25% down using a mortgage at 4%. With 25% down, Mr. and Mrs. Investor have used just $62,500 (as opposed to the full $250k) to purchase the duplex. If they were to do that same purchase three more times, their cash flow would increase to $28,840 (7210*4), a significant increase over the $17,952 cash flow attained with the all cash purchase.
This is a simplified scenario that does not take into consideration things such as closing costs associated with a mortgage and other factors. It simply suggests that purchasing investment property leveraging the bank's money under the right circumstances may have advantages. Buyers need to consider their own goals and financial situations when purchasing property of any kind.