Cash-on-cash return is one of the most widely used metrics in commercial real estate, calculated by dividing annual before-tax cash flow by the total cash invested in a project. It is considered a simple initial evaluation for real estate investments because the cash-on-cash return does not include any other factors that may affect the health of a real estate investment, such as market trends, falling occupancy rates, or any potential change in a property’s value.
This metric is especially important in evaluating assets that are intended to be held for the long term, when cash flow is the key source of income rather than resale. For a passive investor, this metric helps to evaluate the active management approach that will be taken for the property. This is because the pre-tax cash flow gives some indication of the expected expenses that the property manager believes will be incurred for the property outside of debt servicing.
Calculating Cash-on-Cash Return:
Calculating the cash on cash return for a real estate investment is fairly simple “back of the napkin” math. Here is the cash on cash return formula:
As with all simple metrics, validity as a predictive measurement relies on high-quality inputs. The leg work for determining these inputs is where the heavy lifting comes in for the cash on cash calculation. Let’s break down the inputs to see where they come from.
Annual before-tax cash flow: Cash flows into a real estate investment in the form of rent payments. Cash outflows are from operating expenses, such as property taxes, maintenance, management fees, and security services. Finally, if financing was used to buy the property, debt service payments (i.e. mortgage) are considered a tax outflow for the purposes of cash-on-cash return. This amount is typically calculated in the property’s proforma.
Total cash invested: This component is fairly straightforward. It is simply the total cash the investor places in the project. This number, however, can cause a huge fluctuation in the cash-on-cash return depending on how the investor chooses to purchase the property. An all-cash purchase will increase this denominator, while simultaneously increasing the numerator of the equation by eliminating debt servicing cash outflows.
How Financing Affects Cash-on-Cash Return:
This example illustrates how cash-on-cash return on the same property will change given different financing terms:
Doug wants to invest in a property with a purchase price of $5 million. Suppose he has two options for purchasing the property. Assume rental income is the same in all cases.
Example 1: All-cash purchase
Example 2: Loan for 50% of purchase price
Clearly, the decision to finance the purchase of a commercial property, and how much debt is employed, greatly impacts cash-on-cash return.
It is important to recognize that cash-on-cash return is only one tool for evaluating commercial real estate investments. Cash-on-cash is mostly a simple way to compare two similar properties. Simplicity is great, but good investment decisions aren’t made solely on the back of a napkin. There are several factors that are left out of the cash-on-cash return calculation that easily make or break a real estate investment. Resale value, future cash flows (rising or falling rent), macroeconomic factors, and the investor’s tax situation are all ignored by the cash-on-cash return calculation.