Calculating the cash on cash return on a potential investment property is one of the essential metrics in real estate investing. There are so many formulas an investor can use in the real estate industry. Even today, I still perform this simple calculation after seeing a property online that interests me.
What is a Cash on Cash Return (CoC)?
The cash-on-cash return (CoC) is the ratio of the net rental income for the year to the initial investment. The net income is the difference between gross rental income and expenses. Net rental income is also known as cash flow.
For example, if the monthly gross rental income is $1,000, and the monthly expenses are $800, then the monthly pre-tax cash flow would be $200. If the expenses are greater than the gross income, then the rental property has a negative net cash flow.
The total cash investment is composed of all the costs associated with getting your investment property available to rent.
Let’s go over a CoC return example. If the down payment for a property (closing costs included) is $20,000, and the rehab cost $10,000, then the actual cash invested is $30,000.
Therefore, for an annual cash flow of $2,400 ($200 x 12), the cash on cash return formula calculates to be 8%.
Cash on Cash Return Formula = monthly cash flow x 12 / initial investment = $200 x 12 / $30,000 = 0.08 = 8 %
What is a Return On Investment (ROI)?
A Return On Investment (ROI) is another ratio. However, ROI takes into account the total net rental income and the total cash invested.
ROI = total net rental income / total cash invested
Notice how CoC considers the net rental income for a year while the ROI considers the rental income for the life of the real estate investment.
Also, the CoC return focuses on initial investments, such as a down payment and rehab expenses. In contrast, the ROI considers all the actual expenses that occurred, such as a new refrigerator or a new roof.
The ROI indicates the overall performance of the property to an investor. Furthermore, once the investor pays off the mortgage, the ROI will become higher due to an increase in annual before-tax cash flow over time.
What is a Cap Rate?
Cap rate (also known as capitalization rate) is another profitability ratio. However, unlike a cash-on-cash ratio, the cap rate does not consider the initial investments, especially a down mortgage payment.
The cap rate is the ratio of the annual net operating income (NOI) to the current market value of the property. The NOI is the same terminology as the annual pre-tax cash flow.
For example, a property with an annual net income of $12,000 and a market value of $200,000 will have a cap rate of 6%.
Cap Rate = annual net operating income / property market value = $12,000 / $200,000 = 0.06 = 6%
Is Cash on Cash Return Important?
The cash-on-cash return only shows the potential for property investment. That is why it’s a useful metric to understand when analyzing a real estate deal.
However, if an investor wants to know the actual performance of their investment, then they would need to calculate the ROI.
Is Cap Rate Important?
Like a cash-on-cash return calculation, a cap rate can provide the potential of an investment property. However, investors use cap rates when comparing commercial real estate properties to one another.
Residential properties’ market value depends on the purchase price of recently sold similar properties. Appraisers weigh multiple purchase prices to determine market value.
Multifamily units that have at most four units categorize as residential properties. So, their market value depends on the purchase price of recently sold similar properties.
On the other, commercial properties use cap rates for comparisons. The cap rate can help justify the purchase price when seeking approval from a bank.
However, there are other ways to improve the cap rate. Recall that the cap rate is a function of the NOI.
The NOI is the difference between the gross rental income and the operating expenses. Therefore, with either an increase in the gross rental income or the decrease in operating expenses, the cap rate would also improve!
What are some key operating expenses?
The most significant expense is the mortgage. Having a lower interest and a longer-term for the loan can reduce this expense.
Unlike a mortgage, taxes are an expense that will never go away. Unfortunately, taxes will always rise over time, mostly if an investor makes significant improvements to the property.
The way to counter rising taxes is also to increase the gross rental income.
That is why it is essential to consider the location of a property when analyzing a deal. Are property taxes high for a potential investment property? Has there been an increase in rents in the area?
Although real estate websites provide an estimated cost of insurance, investors should not use those numbers. The estimated cost on those websites is for primary homeowner buyers. Investors will have a Landlord Policy, which also means a different premium for insurance.
Instead of getting insurance directly from one of the big-box insurance companies, an insurance broker can provide the right insurance. Insurance brokers are middle-men that will set up with one of the big box companies.
One of the advantages of having an insurance broker is finding other insurance providers if your current insurance provider increases their premiums. If your current insurance company raises premiums, your broker can look for a better deal and can easily switch you over.
For example, one of my insurance providers did not want to continue a policy. There was a break-in within our first month of owning the property. So, it was a loss for them. Check out the post 4 Simple Ways to Secure Your Rehab After Hours to learn about what happened.
Our broker notified us of the situation and quickly found us another insurance provider!
Utilities (Water, Electric, and Gas) and Services
Utilities are usually the responsibility of the tenant. However, it is not uncommon for the landlord to pay for this expense. The same tenant responsibility applies to trash and sewer services.
Home Owner Association (HOA) Fees
Not all properties will be part of a Home Owner Association (HOA). However, if your investment property is a condo or townhouse, there is likely an HOA fee. Like property taxes, it is an expense that will never go away and will increase over time.
New investors with only one property are usually just self-manage the property instead of hiring a property management company. However, if your time is more valuable, leveraging the property management’s time may be worth it.
Property management companies usually charge about 6% to 10% of the gross rental income.
It’s a good practice to always account for property management expenses even if you self-mange the properties. In the case that you need to switch from self-managing to hiring a property manager, you’ve already taken to account that expense.
Furthermore, going with the cheapest property management company to save on expenses is not always a wise decision. Having a lousy property manager could lead to higher costs and headaches.
Repairs and Capital Expenditures
Repairs are simple expenses, such as painting and plumbing. Capital expenditures (also known as CapEx) are big-ticket repair items, such as a new roof, new furnace, etc. I recommend setting aside a percentage of the gross rental income for repairs and CapEx, such as 5% to 10%.
Over time, as you set aside a portion of the gross rental income, you should build a cash reserve to prepare for the scenario when an actual event like that occurs.
Vacancies are another expense that should be a percentage of the gross rental income. Setting aside a portion of the gross rental income could help when you are waiting for a new tenant. After all, investors still have to pay the mortgages!
The percentage to set aside varies depending on the location. If that location is known for having high vacancy rates, then a larger percentage needs to be set aside. Usually, investors set aside 2% to 6% of the gross rental income.
As you wait to build up your cash reserves, we recommend having at least three months of gross rental income in the meantime.
What is a Good Cash on Cash Return?
We aim for a CoC of 10%. However, not all investment strategies are the same. CoC is one of the other metrics used to determine a good deal.
Another thing to consider is location. Is this property in an area that shows appreciation and the opportunity to increase rent over time? Just an increase of $50 to $100 to change a CoC from 8% to 10%.
I’m not recommending purchasing a property with the assumption that a property will appreciate or rent prices will increase. What I’m suggesting is to do additional real estate analysis and use conservative numbers!
As a real estate investor, you need to focus on the numbers to avoid overwhelmed and emotional over time. However, don’t get too hung up on the numbers that you get locked up in “analysis paralysis.”
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Cash on Cash Return Calculator
Looking for a rental property calculator? Look no further! Top real estate investors still use cash-on-cash return to help them analyze a deal.
This calculator can help determine the cash flow relative to the cash initially invested and quickly show a property’s potential return!
One of the benefits of having a rental real estate property is that the tenants are taking care of the debt service payments. The cash-on-cash return metric helps you determine if you’re getting a greal deal.
However, a satisfying cash-on-cash return depends on much cash you invest in the deal. You should strive to generate at least $100 in net cash flow.
If you’re interested to learn more, be sure to check out my beginner’s guide to real estate investing!