What is a Cash on Cash Return?

August 20, 2021
Categories: All Getting Started

There are several metrics investors use when evaluating various investment opportunities. Metrics like cap rate, internal rate of return (IRR) and cash-on-cash return allow investors to make a quick, apples to apples comparison of the opportunities before them. Some investors have certain thresholds (i.e., the metric must hit a certain number) for them to pursue the deal in earnest. Many investors look at hundreds of deals before investing in any single one, so these metrics help them wade through the masses before focusing their attention on a select few.

In this article, we look at "cash on cash" returns as a metric some investors use to evaluate investment opportunities.

Related: Real Estate Investment Trends in 2021

How to Calculate a Cash on Cash Return

Cash on cash return is a rate of return ratio that calculates the total cash earned on the total cash (equity) invested in a deal. It is defined as cash flow before tax (i.e., cash flow after financing) in a given period, divided by the equity invested as of the end of that period. Cash on cash return is a levered (i.e., after-debt) metric, whereas the "free and clear" return is its unlevered equivalent. Cash on cash return is a metric used by real estate investors to assess potential investment opportunities. It is sometimes referred to as the "cash yield" on an investment.

The cash on cash return formula is simple:

  • Annual Net Cash Flow / Invested Equity = Cash on Cash Return

The cash on cash return is generally expressed as a percentage. While this ratio can be used in several business settings, it is most commonly used in commercial real estate transactions.

By way of example: Let's say a sponsor decides to purchase an apartment building for $10 million. The sponsor pools $2.5 million of equity to invest in the deal and then finances the remaining $7.5 million. Aside from the down payment, the sponsor paid $200,000 in various closing costs and fees. Therefore, total equity invested is $2.7 million.

After one year, the annual rental revenue from the property is $1.2 million. In addition, mortgage payments, including both principal and interest payments, total $550,000. The sponsor spends another $200,000 on operating expenses and property improvements.

To determine the cash on cash return, you must first calculate the annual cash flow from the investment. The annual cash flow from the first year is:

  • Annual net cash flow = total gross revenue - total expenses
  • Annual net cash flow = $1.2 million - $750,000
  • Annual net cash flow = $450,000

Now, we divide the annual net cash flow by equity invested to determine the cash on cash return.

  • $450,000 / $2,700,000 = 16.7%

The property's total cash on cash return is 16.7%. TIs means that the property's annual profit for that year will be 16.7% of the cash initially invested.

Do you need a new investment? Explore why you should diversify your investments with self-storage units.

Benefits of a Cash on Cash Return

There are many reasons why investors like to calculate a property's cash on cash returns.

The first, most practical use of cash on cash return is for property selection. Cash on cash return allows investors to conduct a quick, side-by-side analysis of multiple deals based on the information available to them (i.e., the rent roll, operating expenses and other financials provided by the seller).

Another reason investors like to use cash-on-cash return compared to other metrics is that it factors in the cost of financing. This helps investors determine what terms they'd need in order to achieve a certain cash on cash return. When an investor has more equity in the deal (as a percentage of the loan-to-value), the cash on cash return will generally be lower than if an investor has less equity in the deal. The calculation skews downward as more equity is invested, assuming revenues and costs remain constant otherwise. Of course, the cost of financing can also impact the cash on cash return and therefore, this calculation can motivate an investor to shop around for better loan rates and terms.

Finally, cash on cash returns provide useful insights as to a property's expense profile. Properties with higher expenses will result in lower cash on cash returns, assuming all else remains equal. A prospective buyer might look at the current expenses to determine if there are cost savings that can be implemented to increase cash on cash returns.

Related: Why Is Real Estate an "Alternative" Investment?

How Cash on Cash Returns Compare to Other Metrics

The cash on cash return is one of many metrics that investors can use to evaluate investment opportunities. It differs from other metrics as follows:

  • Cash on Cash vs. ROI: A property's return on investment is used to measure the overall rate of return on a property, including debt and cash, while cash on cash measures the return of the actual cash (equity) originally invested.

  • Cash on Cash vs Internal Rate of Return (IRR): The IRR is defined as the total interest earned on money invested. The primary difference between cash on cash returns and IRR is that IRR is based on total income earned throughout the ownership cycle (vs. in annual segments, as is the case with cash on cash returns). IRR calculations are much more complicated and are based upon the time value of money financial principle.

  • Cash on Cash vs. Cap Rate: The cap rate calculation assumes there is no debt on the property. If a property was purchased with all cash (i.e., there is no debt service obligation), then the cash on cash return would be the same as the cap rate. However, because most investors use some degree of leverage, these are generally different calculations.

What is a Good Cash on Cash Rate of Return?

Many investors want to know what is a "good" cash on cash return. There is no easy answer. A "good" cash on cash return depends on several factors, including an investor's preferences. For example, a risk-adverse investor might opt to invest more equity into deals, thereby lowering how much leverage they need. The more equity, the lower the leverage and cost of financing, the lower the cash on cash return. For some investors, an 8-10% cash on cash return is sufficient if the property otherwise meets their investment objectives. Others might only look at deals with a minimum 20% cash on cash return. These investors might need to utilize more leverage and less equity to reach that threshold.

The local market also influences cash on cash returns. In particularly hot markets, higher acquisition costs might require substantially more equity (in total dollars, not as a percentage of loan-to-value). Unless income is comparably high, the total cash on cash return might be lower. Many investors are willing to accept a lower cash on cash return in primary markets with strong underlying economics, particularly if they are risk-adverse and/or have a long investment horizon.

One way for an investor to compare deals using cash on cash returns is to assume the same amount of equity is invested in each deal. Let's say an investor has $2 million to invest. They can use that $2 million to invest in three separate deals. Based on the debt, income and expenses associated with each of those deals, assuming equity invested remains constant, the investor can determine which of the three deals results in the highest or "best" cash on cash return.

Related: Terms and Definitions: Debt Terms

The Bottom Line

Ultimately, cash on cash return is a metric that can be used to steer investors as they determine which investment will be more or less profitable when compared to others - assuming the same equity could be invested in a variety of ways (including but not limited to real estate investments). Cash on cash returns are a useful metric but are always best used in conjunction with other real estate investing metrics like those outlined above.

If you have any questions about self-storage investments or would like to get started with investing, reach out to us and we will get back to you as soon as possible.