[Editor's Note: The following post is from WCI Network partner, Passive Income, MD and is about evaluating investments using the cash-on-cash return metric. We sometimes forget that basic division can give an insightful first look at an investment's potential yield. Enjoy!]
What’s the best way to evaluate an investment?
Someone posted in on our Facebook group, Passive Income Docs, recently about the desire for a certain return on investment (ROI).
Though we talked about many potential ways to evaluate investments, one interesting thread of the discussion was based around cash-on-cash (CoC) returns vs internal rates of return (IRR).
It’s always tricky figuring out how to best evaluate an opportunity, so I thought it might be important to discuss and explore key terms like this. They’re integral to understanding the various investments we come across in crowdfunding, syndications, funds, and rental real estate.
The cash-on-cash return, specifically, is one of the simplest and most effective ways of calculating the return an investment will likely yield.
How Do You Calculate Cash-on-Cash Return?
Like most real estate calculations, it’s pretty simple. You take the amount you receive (in cash) from your investment and divide by the total amount you invested. Use the pre-tax amount as the numerator.
So for example, let’s say you put $10,000 into a real estate crowdfunding deal (Total Cash Invested) and you receive $1000 over the course of the year (Annual Before Tax Cash Flow). This scenario yields a 10% cash-on-cash return ($1000/$10,000).
When looking at a rental property it might look something like this:
Net Operating Income = Revenue (Rent + Other Income) – Expenses
Debt Service = Mortgage Payment (Principal + Interest)
Strengths of Cash-on-Cash Return
Simplicity
The greatest strength of the cash-on-cash calculation lies in its simplicity. While metrics like Internal Rate of Return can be quite confusing, people can wrap their heads around this calculation much more easily. You simply put a certain amount in and you get a certain percentage return back in your pocket.
Helps You to Compare Investments Quickly
You can also use CoC to compare investments quickly. If you have an average of what an investment might yield, as well as how much you may want to invest, the CoC calculation can quickly help you see the investments with the highest return potential. As a preliminary comparison tool, it’s hard to beat.
See How Changing Certain Factors Could Affect Your Returns
You can use it to evaluate an investment after changing certain factors like how much you leverage the property.
For example, if you paid all cash for a certain property and you received a certain amount, you might receive an 8% return. But what if you used leverage instead by taking out a loan and putting down 30%. How does that change your return? One way to assess these different scenarios is by using cash on cash return and that might help you determine how much leverage to use.
Encouragement and Motivation
Cash-on-Cash return provides a good amount of encouragement and motivation. It’s nice to watch your stock portfolio go up and down, but to me, nothing is as exciting as getting that check or deposit at the beginning of each month from my cash-flowing passive income ventures. Even though it takes some work to get there, that extra check feels like a monthly bonus.
It’s encouraging to see and to know that you didn’t have to put in an extra call night at the hospital to receive that deposit. It pushes me to do more and makes me hungrier for more time freedom.
You Can Live Off of It
Finally, if you’re using the cash flow from certain investments as passive income to live off of and retire gradually like I am, using your cash-on-cash evaluation is huge for knowing if you’ll have enough to cover your expenses. If your passive income provides that type of positive cash flow, you can live the life you want.
For example, if your passive income goal is $10,000 a month through investments ($120,000 a year), and you get an 8% cash-on-cash return from a total of $3,000,000 in investments out there working, you’ll most likely have exceeded your goals after taxes. To do that calculation quickly:
3,000,000 x .08 (cash on cash return) = $240,000
And how do taxes affect things? Read on.
Weaknesses of Cash-On-Cash Return
Regarding Taxes
Cash-on-Cash return doesn’t take taxes into account. Everyone’s tax situation is different, as is how the investments are treated. It’s important to consider where you live as well as the concept of depreciation.
For example, I live in a high cost-of-living area, in California, where the state income tax at the highest bracket is 13.3%. My friends living in Texas, where the state income tax is a big fat 0%, would look at CoC returns very differently than I would.
What is depreciation? Well, the IRS allows you to depreciate the cost of a residential real estate property over 27.5 years of useful life (residential real estate) and offset your rental income. It’s a huge benefit of investing in real estate.
Underreports Your Profit Potential
The CoC calculation may also underreport your actual profit, as it doesn’t take into account mortgage or principal paydown and appreciation. Sure you end up with a certain amount in your pocket monthly or by the end of the year, but that’s only part of the profit picture.
While your mortgage is being calculated as an expense, in reality, a portion of it goes toward the interest payment and a portion goes toward paying the principal down. So it is being paid off over time by your tenant, increasing your equity position in the property.
Speaking of equity, over time the property is likely appreciating in value. That doesn’t show up as yearly money in your pocket while you hold it, but it will definitely show up when you go to sell the place.
Should You Evaluate Using Only Cash-On-Cash?
Well, the answer is no. There are other factors at play, including risk and opportunity cost and Cash-on-Cash doesn’t account for them. Because both are important ideas to consider, let’s take a look at each.
Risk
Returns often correlate with risk. So if you’re going strictly by what can get you the most returns without taking into account risk, you probably went heavy in bitcoin when it was fluctuating wildly and was frenzied.
In real estate, you have to look at risk as well. What kind of project are you pursuing? For example, ground-up development can have amazing potential but there’s also a ton of risk involved. Paying close attention to risk is always important in addition to just a pure Cash-on-Cash Return number.
Opportunity Cost
Are there better places to put your money? Well, if you decide by only using a CoC calculation, you might be tempted to think about opportunity cost and always chase the highest cash-on-cash.
For example, many have struggled with the idea of the “pay down debt vs invest” dilemma. Basing that decision on cash-on-cash would tip the scales in one direction, but paying down debt is essentially a guaranteed return. It’s lowering the interest that you would definitely be paying in the future. In situations like these, CoC may not be the best fit for your decision-making process.
The Bottom Line
There’s a huge difference in investing purely for speculation versus investing for cash flow. Positive cash flow allows for operations to continue when revenue drops a bit.
It’s steady, and it’s why, in 2008, owners of rental properties that had cash flow didn’t bat an eye. Speculators, developers, and fix and flippers, on the other hand, got crushed.
Positive cash flow is a good metric that keeps you from overleveraging and putting yourself in a tough financial situation.
Ultimately, my goal is to help you look at investments wisely and smartly as I’m learning how to continually improve myself in the same way. Understanding how to vet opportunities starts with the numbers, and I can’t think of many better places to start by looking at the cash-on-cash return.
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How important do you think this metric is? How do you use cash-on-cash return to decide what investments to make?
Everyone should understand CoC returns for sure.
There is a danger in maximizing it though.
The use of “leverage” otherwise known as DEBT is the easiest way to double or triple your CoC returns.
That covers up the cost and downside risk of over-leveraged projects gone bad.
Speaking from the point of view of a real estate investor, it’s ultra important to be aware of both your cash on cash as well as total return on both INITIAL equity and CURRENT equity. It can be deceiving to only count cash on cash. For example, let’s consider real estate where there are “four ways” to make money (I posted a chapter from my book on RE investing on this subject here: http://re-rebel.com/four-ways-profit-re.html) -One of the most underrated return metrics is “debt paydown”. For example, if you purchase a 100K fourplex, using 25% down and 20 year financing, at the end of 20 years, you will have earned an annualized 6.8% JUST from the virtue of having your “tenants pay your mortgage” so to speak. This is without counting the tax consequences of depreciation, without any price appreciation, and assuming zero cash flow (i.e. the property broke exactly even month after month, year after year), and at the end of 20 years you sold it for the exact 100K you bought it for. (To backup this hypothesis, simply calculate what you’d need to earn, percentage wise, if you put 25K in a mutual fund and wanted it to grow to 100K in 20 years). This does NOT factor in buying and selling costs, but I fudge those out, because even without appreciation, I think after 20 years, we can “let slide” just enough appreciation to cover buying and selling costs, if for no other reason to simplify our example.
So if you’re comparing investments, and a mutual fund promises to return 9% and a rental property only shows a 7% cash on cash return, it pays to factor in that 7% debt paydown return. The catch is that you have to hold the property the whole 20. Because mortgages are front loaded, your return will be lower in the earlier years, then higher in the later years. The other catch of course is that cash flow has to AT LEAST be enough that you’re not negative cash-flowing, which lowers your return.
I agree that total return matters more than cash on cash.
Not sure I agree with your fuzzy math on the debt paydown (not just transaction costs either- maintenance, vacancy etc), although I do agree that’s a significant source of return. I think it is also not an easy proposition to have a 20 year mortgage on a 25% down property that is actually cash flow neutral. There’s a decent chance you’re going to be feeding that property, at least for a while.
Could you do a hypothetical article about buying a property and explaining how much rent to charge versus how much the place cost and figure out the tax savings?
You should charge as much rent as you can get- i.e. what similar properties charge for rent. The better the rent to cost ratio, the better. Not sure what tax savings you’re talking about. All of your expenses, including mortgage interest, are deductible. You can depreciate the property over 27.5 years. So if you bought a $300K property and $100K of it is the land and $200K is the building, you can shelter $200K/27.5 = $7,272 of income per year from taxation. In the beginning, that’s probably a big chunk, maybe all of your profit. Later, as you increase rents, it won’t be. If you sell, that depreciation is recaptured. If you exchange or die, it never is.
Hope that helps.
A general rule of thumb most investors use is that you should be able to get 1% of the cost in rent. If the property costs $100K you should be able to get $1,000/month in rent. If that’s over the market for the type of property you bought then you paid too much.
When you evaluate the total expense you also have to factor in your monthly addition to the replacement reserve as that’s usually not considered in the NOI and it definitely decreases your true monthly cash flow (money in your pocket). Also other capital improvement expenses are considered non-operating expenses as they decrease the cash flow if not covered by the replacement reserve.
In my education on investing over the past few years, I have yet to find another asset class that has such system wide support for leveraged investing as real estate. In terms of the economic infrastructure available to real estate investors (like low interest loans, insurance, tax write offs from depreciation, and step up in basis upon death), it seems almost too good to be true.
I would agree, though, that solely focusing on cash-on-cash returns sends one down the path of ever-increasing ratios of leverage to equity, which some would argue introduces too much risk.
I’m curious how much equity Dr. Dahle generally puts into his rental real estate ventures?
I don’t own individual properties any more, I’m pretty much all in syndications and increasingly funds of syndications. But the equity deals are generally about 2/3 LTV.
Thanks for the reply! It gives me food for thought. I have a romantic notion of growing a real estate empire that will provide cashflow and financial security, but have yet to enter this arena. Well vetted syndications certainly seem like a good alternative with their own advantages and disadvantages.
What is 2/3 LTV ? And what syndications are good?
What is 2/3 LTV ? And what syndications are good?
2/3 LTV means two thirds Loan to Value ratio.
I would expect this to mean that for every $100k property purchased, approximately $33.3k would be put down as a downpayment, with the remaining $66.6k being financed with a mortgage loan.
Typically, primary residences are financed at 20% down, while investment properties usually require at least 25-30% “down”. There are more exotic mortgage products out there that can change these numbers.
Syndications are very dependent on the track record of the syndicator and the quality of the development / property. Most people recommend only going into syndications where someone you know can vouch for the integrity of the syndicator (the person running the deal).
There’s a lot of nuance to this, and I would add that I have not participated in any syndications yet.