Evaluating your cash-on-cash return is an important metric for investing in any type of real estate property. That’s because it can give you an idea of how hard your money is working for you when compared with other investment opportunities such as the stock market.
What is cash-on-cash return?
A cash-on-cash return, sometimes known as CCR, is an easy concept because it is basically the cash you get back each year on the cash you invested in a property. It differs from your return on investment (ROI) because ROI looks at the return on the whole investment, including debt. Here’s how you calculate cash-on-cash returns.
Cash-on-cash return = Net operating income (NOI) / Total cash invested x 100%
Let’s say you purchase a rental property for $100,000 as a potential investment. You put 20% down on a mortgage and pay $5,000 in closing costs for a total of $25,000 cash down in the deal. Your net operating income (NOI), or your pretax profit after you take in rental income but deduct operating expenses, is $3,000 per year. To get your cash-on-cash return, you’d divide $3,000 by $25,000 to get a 12% cash-on-cash return.
If you did not mortgage that property, you would have $105,000 cash in the deal, but your NOI would be higher, because you wouldn’t have debt service expenses. Let’s say that made your NOI $8,500 annually. Divide $8,500 by $105,000 and you have an 8% cash-on-cash return. This cash-on-cash return can fluctuate over the course of your holding period in the event you have one-time capital or other large expenses such as fixing a roof.
What’s a good cash-on-cash return?
Those figures are pretty darn good by most investing standards, especially if you can increase it by leveraging the property with a mortgage, and when you consider the average stock market return is around 8%. But you’ll want to shoot for a much higher cash-on-cash return to make the effort of securing the property, managing the property, and building value into the property worthwhile over time. Your cash-on-cash return also does not include potential appreciation or depreciation to the property over time, which affects your overall ROI.
Your ability to achieve a double-digit cash-on-cash return depends largely on the market in which you buy, and the type of asset you acquire. Class C and D assets, which are older properties in less desirable neighborhoods, tend to yield higher cash-on-cash returns than properties in very desirable neighborhoods where sale prices are high and require more cash for the deal. These Class C and D properties often need work, but offer the opportunity to add value by filling tenant vacancies or increasing rents. That said, these asset classes are also much riskier and involve more headaches.
Some investors compare their cash-on-cash return targets to dividend yields for real estate investment trusts (REITs), in order to align their expectations with what the broader, publicly traded REIT market is doing. But because you have to actively manage a property you purchase yourself, you may want to aim for a higher cash-on-cash return in order to compensate yourself for the effort.
Compare it with other metrics
At the end of the day, cash-on-cash return is just one piece of the evaluation you should be conducting each time you wish to invest in a property. Other metrics include NOI, capitalization rate (also commonly called cap rate), internal rate of return (IRR), cash flow, and potential appreciation of the asset. You also want to assess the property’s individual risks and management requirements. One or more of these other factors could make a deal with a seemingly low cash-on-cash return more attractive because it meets your goals.