Cash-on-Cash Return: What It Means and How To Calculate

A Simple Guide to Understanding Cash Flow, Profitability, and Investment Planning

Whether you're an experienced real estate investor growing your portfolio or you're diving into the world of real estate for the first time, you'll want to know if a property will be profitable before moving forward. Since real estate investing comes with risk, estimating how much cash a property brings in each year can help guide investors toward more informed decisions. That's where cash-on-cash return comes in, which can help you estimate your cash flow on potential investment opportunities.

Here's a breakdown of how cash-on-cash return is calculated and other considerations when evaluating the cash flow of an investment property.

What Is Cash-on-Cash Return in Real Estate?

Cash-on-cash return measures the amount of pre-tax cash flow a real estate investor can earn each year compared to the actual cash they put into an investment property. Simply put, it shows investors interested in buying an investment property how much cash properties generate each year relative to how much money they plan to spend on the property, including upfront expenses like a down payment, closing costs, and initial repairs.

When assessing investment property opportunities, this formula can help real estate investors understand the amount of cash they may earn from the money they invest. Investors can also use it to weigh financing options and decide how much of the investment should come from property loans and how much should come from their own cash.

How to Calculate Cash-on-Cash Return

Calculating cash-on-cash return is pretty straightforward after you break it down into a few simple steps. Remember that the goal is to compare how much pre-tax cash flow a property generates each year to the total initial investment.

Cash-on-cash formula: Cash-on-cash = (annual pre-tax cash flow / total cash invested) * 100

Here is a step-by-step breakdown of how to calculate it:

• Step 1: Find gross operating cash flow: This number includes the property's rental income and any other income it generates.
• Step 2: Find net operating income (NOI): Start by subtracting the property's operating expenses from your gross operating cash flow. Operating expenses include property taxes, insurance, maintenance, and management fees.
• Step 3: Subtract debt service to find pre-tax annual cash flow: Debt service includes your annual mortgage payments (principal and interest). Next, subtract your debt payments from your NOI to calculate your annual pre-tax cash flow. Remember that cash-on-cash return is calculated using the cash flow earned before taxes are deducted.
• Step 4: Add up your initial investment: Your total cash invested can include your down payment, closing costs, and any initial renovation expenses.
• Step 5: Divide your annual pre-tax cash flow by your total cash invested: The result is your cash-on-cash return, which is usually expressed as a percentage.

Considerations When Using the Cash-on-Cash Formula

Cash-on-cash return can help you estimate how much money a property may make in a given year, but it doesn't exactly paint the full picture. Since this calculation relies heavily on estimates and assumptions, it's important to be objective when using this formula to evaluate an investment.

This means that you'll want to include all of your expected common expenses, such as periods when the property is empty, repairs, maintenance, and property management fees. If you leave out some expenses, the return may look a lot more appealing on paper than it will be in real life.

Investing in real estate comes with risks, and many factors impact whether (or not) a property will yield a profit. With this in mind, it's important to remember that cash-on-cash return is just one metric and doesn't include all data points that can make a significant difference when deciding on an investment. For example, cash-on-cash return only considers pre-tax cash flow, which means it leaves out other ways a property 's value can grow, such as appreciation, paying down the loan, or tax benefits.

It also measures performance over a short period, usually one year, and doesn't factor in things like changing expenses, income fluctuations, long-term gains, or future property improvements. Because of this, cash-on-cash return is best used alongside other metrics to get a more complete picture before making an investment decision.

Why Cash-on-Cash Return Is Important for Investors

When a property has a strong cash-on-cash return, this can indicate that it's a profitable opportunity. It can also help set investor expectations for future income. By comparing a property's income against the money invested, this metric helps investors get an idea of potential income, rather than a complete picture of overall performance.

Investors typically use cash-on-cash return to compare different real estate investments and understand a property's cash yield, or in other words, how much cash it may generate each year.

While it doesn't measure any long-term growth on its own, it can help investors gauge whether a property may be able to cover ongoing expenses, debt payments, and income goals.

At the same time, cash-on-cash return does not directly measure equity growth from appreciation or loan paydown, but it can still help guide equity-related decisions when paired with other metrics that track long-term value.

Other Metrics Real Estate Investors Track

As mentioned earlier, the more information you have for your estimates, the better you can evaluate an investment opportunity. So, in addition to using cash-on-cash, you'll want to review several other metrics, which can include:

• Internal rate of return (IRR): Cash-on-cash focuses on short-term profitability, usually measured year-over-year, whereas IRR shows how profitable an investment could be over time, which can give you a more accurate estimate of long-term performance.
• Net operating income (NOI): Cash-on-cash illustrates the amount of cash an investor can earn on their investment. NOI, on the other hand, shows how much income a property produces after expenses, before loans or taxes.
• Cap rate: While cash-on-cash looks at investor cash yield, cap rate looks at how profitable a property is based on its income generation and purchase price, before loans are included.

Cash-on-Cash Return Example

To give you an idea of how cash-on-cash works, let's say an investor is considering the purchase of a rental property. If we assume the property generates $4,800 per year and the investor's initial investment is $45,000, here's how the math would work out:

• Total cash invested: $45,000
• Down payment, closing costs, and initial repairs: (included in $45,000)
• Monthly cash flow: $400
• Annual pre-tax cash flow: $4,800

Cash-on-cash return calculation:

$4,800 ÷ $45,000 x 100 = 10.7%

In this example, the investor could earn roughly a 10.7% cash-on-cash return each year. Keep in mind, however, that this estimate doesn't include other forms of equity growth, such as appreciation, principal paydown, or tax benefits, or ongoing property expenses that could change over time.

Cash-on-Cash Return FAQs

Curious to learn more about real estate investing and how cash-on-cash return can help estimate profitability? Here are answers to some common investor questions.

Is Cash-on-Cash Return the Same as ROI?

No, cash-on-cash return and return on investment (ROI) are not the same. Cash-on-cash return specifically looks at a property's cash yield compared to the initial investment, while return on investment (ROI) looks at the property's overall performance, which includes long-term factors like appreciation and paying down loan debt.

What Is a 'Good' Cash-on-Cash Return?

There's really no single "good" cash-on-cash return, since it can change based on many different factors like market conditions and investor goals. However, generally speaking, investors tend to use a cash-on-cash return between 8% and 12% as a benchmark.

Is Cash-on-Cash Return Before or After Taxes?

Cash-on-cash return is usually calculated using pre-tax cash flow. In other words, it measures income earned before taxes are taken out and doesn't reflect a real estate investor's individual tax situation.

Final Thoughts: Using Cash-on-Cash Return for Smart Investing

Investing in real estate can be both exciting and overwhelming, especially if you're just beginning to build your real estate portfolio. Using a variety of metrics like cash-on-cash return can help you estimate potential cash flow and assess whether an investment is worth considering. Before moving forward, it's worth taking the time to think through financing options for the property, the responsibilities that come with ownership, and how it fits into your long-term financial goals. Freedom Mortgage is always available to help you with any related questions.

When you're ready, getting prequalified with us can be a good place to start.