Let’s be honest:
Real estate investing can be hard.
After all, you don’t have a crystal ball that can tell you what the future holds.
So how can you make a wise choice when choosing a rental property?
Do you guess?
Do you rely on gut feelings or hunches?
Here’s the truth: you can take the guesswork out of real estate investing with several formulas, including cash on cash return.
Cash on cash return can tell you how profitable a rental property will be, even before you purchase it.
Or, if you already own a property with a poor cash on cash return, here’s the good news: you can improve it!
Keep reading to learn everything you need to know about cash on cash return.
What is Cash on Cash Return?
Cash on cash return determines the income you could potentially earn as a percentage of the cash you will invest in a property on an annual basis.
The formula allows you to break down a given rental property’s cash flow (without debt) so that you can clearly see the profitability of a property — and if it’s right for you and your real estate investing portfolio.
The formula used to calculate cash on cash return is:
Cash on Cash Return = Annual Pre-Tax Cash Flow / Total Cash Invested
To get the annual pre-tax cash flow, you follow this formula:
Annual Pre-Tax Cash Flow = (Gross scheduled rent + Other income) – (Vacancy + Operating expenses + Annual mortgage payments)
Next, we’ll take a look at its advantages and disadvantages.
Advantages of Cash on Cash Return
Among the key advantages of the cash on cash return formula are:
- Helps you determine the best short- and long-term rental markets
- Helps you select well-performing rental properties for sale by comparing different opportunities
- Breaks down the profitability of their property based on the amount of cash invested
Disadvantages of Cash on Cash Return
Meanwhile, the key disadvantages of the cash on cash return formula are:
- It’s more difficult to calculate compared to other return on investment metrics in real estate (such as cap rate)
- It factors in pre-tax cash flow and does not consider how taxes impact the profit from real estate deals. This is a downside because sometimes taxes can have a significant impact, especially in markets with high property tax and income tax rate
- Requires access to both short- and long-term data to calculate the cash on cash return from one or more properties
What is a Good Cash on Cash Return for a Rental Property?
There’s no hard and fast rule on what makes a good return rate, as it still largely depends on individual circumstances. However, a cash on cash return of 8% to 12% is considered very good.
Anything higher is even more advantageous, while a percentage in the 5% to 7% range is acceptable.
Lower than 5% shows a very low profitability for a rental property.
But again, it depends on your situation … for example, if you’re a beginner real estate investor looking for your foot into the door, a 5% cash on cash return might sound swell to you.
What Expenses to Consider in a Cash on Cash Return Formula
What expenses should be taken into account when calculating cash on cash return?
- Utilities
- Maintenance costs
- Vacancy rate
- Mortgage
- HOA fees (if applicable)
- Property taxes and insurance
- Property management fees
Coming up with an itemized list of monthly expenses and rental income may come in handy when it’s time to calculate your cash on cash return.
How to Calculate Cash on Cash Return Without a Loan
Imagine the following investment scenario: you purchase a rental property that costs $250,000.
You pay the full amount in cash and another 5% for rehab and closing costs.
(Rehab costs are important to factor in because, without them, you can’t really rent out your property.)
The total additional costs would then add up to $12,500.
To break down:
Total Cash Investment = $250,000 + $12,500 = $262,500
Let’s say you charge $2,100 monthly for the rental property. To compute:
Annual Rental Income = 12 x $2,100 = $25,200
Factoring in the operating expenses at 1/3 of the rental income, then would lead us to:
Annual Pre-Tax Cash Flow = 2/3 x Annual Rental Income = 2/3 x $25,200 = $16,800
Finally, breaking down the cash on cash return using the formula we outlined above:
Cash on Cash Return = Annual Pre-Tax Cash Flow / Total Cash Invested
$16,800/$262,500 = 6.40%
The cash on cash return you can possibly generate from this rental property is 6.40% if it’s bought in cash.
How to Calculate Cash on Cash Return With a Loan
Now, if the rental property is not paid in cash, you will need to take a bank loan before purchasing the property.
Let’s say you are buying the same $250,000 rental property in the previous example and paying 25% in cash as a down payment:
Down Payment = 25% x $250,000 = $62,500
The same rehab and closing costs at 5% of the total value are also up to $12,500.
To calculate:
Total Cash Investment = $62,500 + $12,500 = $75,000
Notice a slight difference in this cash on cash return calculation. This is because we are only considering the cash money paid right away (the down payment) and not including the bank loan.
Then, we need to calculate the annual pre-tax cash flow. In addition to the rental income (+) and the operating expenses (-), we need to add the debt service (-) to the equation.
Let’s assume an interest loan yield of 8%, which is fairly common:
Debt Service = 8% x $187,500 = $15,000
Then:
Annual Pre-Tax Cash Flow = $16,800 – $15,000 = $1,800
To get the cash on cash return:
Cash on Cash Return = Annual Pre-Tax Cash Flow / Total Cash Invested
$1,800/$75,000 = 2.40%
The cash on cash return that the investor can generate from the rental property if they take out a bank loan, in this scenario, is 2.40%.
Cash on Cash Return Vs. Other Real Estate Investing Formulas
Let’s briefly examine how cash on cash return differs from other real estate investing formulas.
Cap Rate
Cap rate, or capitalization rate, calculates the return on the property whereas cash on cash calculates the return for the investor.
Whereas cash on cash return will vary from property to property, cap rate — which is found by dividing the net operating income by its market value — will likely be the same percentage for many investors in similar markets.
ROI
Return on investment (ROI) is also a widely used metric that measures the overall return on the entire invested amount, both cash and debt. It differs from the cap rate in that it considers the property price and the cash on cash return considers the cash investment.
GRM
GRM, or gross rent multiplier, is found by dividing the property’s market value by the annual gross income. As opposed to cash on cash return, GRM is typically used to see if a property is underpriced or overpriced.
How to Improve Your Cash on Cash Return
If you fall in love with a property that has a poor cash on cash return, or you’re experiencing one in real time, what can you do?
Here’s the good news: you can improve your cash on cash return.
First, you can improve your property’s value with renovations or improvements to collect higher rent payments in the near future.
Another option, though difficult, is to raise the rent with your current tenants. The key here is to not raise the rent so much that it leads to vacancies, which greatly affect your cash on cash return.
Or, if you are utilizing a property management company or have other fees tied to your rental property, you can lower your operating costs to improve your cash on cash return.
The Bottom Line: Cash on Cash Return
You can take the guesswork out of real estate investing with the cash on cash return formula.
That is, if you know how to use it properly.
Use this guide to calculate your current or potential cash on cash return so that you can make a profitable decision that will impact your return now — and in the future.
