Cash on cash return is another useful simple economic metric that is used primarily used in the USA when assessing real estate investments, particularly in the commercial real estate sector. It is one of several simple metrics that include ROI and cap rate that allows you to conduct a quick investment napkin or acid test.
Together, this ensemble of metrics can give you some basic data to analyse ahead of a potential investment.
The cash on cash return is a relative measure of net income compared to the initial investment. In essence, then, it identifies what cash comes in on what cash goes out.
This is calculated simply as total cash flow before tax divided by the initial investment.
Cash on cash return = Annual pre-tax cash flow / Total cash invested x 100%
A key aspect of cash-on-cash return is that it provides an annual measurement based on investment cash only, and thus, it differs from ROI that can be a much more complex or progressive measure.
As shown, cash on cash return calculates the cash flow pre-tax divided by the initial full investment. The full investment here includes all costs associated with a year’s running of the property.
Some of these include:
- Initial fees and insurance
- Maintenance costs
- Ground rent
- Property management fees
ACME Development purchases an office block for £1 million. This involves a £200,000 down payment and an £800,000 mortgage.
£20,000 fees will be incurred within the first year. Annual mortgage payments are £30,000. The annual rental income is £120,000.
Determining the annual cash flow: Annual cash flow = rent minus the mortgage payments. So, £120,000 – £30,000 = £90,000 cash in.
The investment cash out is the downpayment and fees. So, £200,000 + £20,000 = £220,000.
We can now calculate the cash on cash return.
Annual pre-tax cash cash flow in of £90,000 / total cash invested of £220,000 = 0.41 = 41%
Cash on cash returns is a fairly simple metric that is optimal for year 1 calculations only. After then, it is superseded by other measures. For example, across a 10 year period, cash on cash return compared to internal rates of return may underestimate investment value considerably. This is because cash on cash return is not a longitudinal measure that takes into account 9/10 years of this investment period. Also, cash on cash return factors only a simple interest rate and not a compound interest rate. It is also a pre-tax metric, and thus, does not accurately assess profitability without knowledge of how income will be taxed.
IRR is a more long-term complex measure of investment. IRR measures the estimated return from the entire project using the initial costs and cash flows over longer periods of time factoring in reinvestment and compound interest. Operating cash flows tend to build over the investment period and this favourably influences the figure the longer that period is. This could be counterbalanced by increased operating costs.
ROI meaning return on investment does not really have a fixed definition. At its simplest, it is the total investment gain divided by the total costs. Obviously, this factors in many large assumptions as it stands.
A simple example would be a land purchase of £1 million where the buyer rents the land to festivals each summer, and breaks even on all operating costs, including any loan or mortgage payments.
They then sell the land for double what they paid.
The ROI here would be £2,000,000 – £1,000,000 / £1,000,000 = 1 or 100%
The return on this investment is 100% of the total cost.
ROI then differs to cash on cash return as it measures the entire scope of the project (albeit crudely). Cash on cash return concerns cash flows over a given period (e.g. a 1 year period).
These two measures are more readily compared as they both cover a given investment period, usually 1 year. However, the cap rate uses the net operating income and divides this by the purchase price. The cash on cash return uses cash flow pre-tax divided by the initial investments.
The cap rate concerns the return on the property itself, not the cash flow.
There are many metrics available when calculating the financial ins and outs of an investment. Some are rough and ready, easily calculable from little data (e.g. cap rate and cash on cash return). Others are much more complex (e.g. IRR and NPV). Each metric gives you something to work with, but none can tell the whole picture independently from each other. Knowing when to use the right metric and how to look into it is critically important. The last thing you want is a heap of useless numbers in a spreadsheet with no real context.
Cash on cash return concerns cash flow. It calculates the remaining cash flow relative to the investment. This is where it gets its name; it’s the cash in on the cash-out. It’s useful when cash flows are regular, predictable and consistent.
- A buy to let project involves an investment of £1,600,000. The income from this must cover living costs of £120,000 a year pre-tax. This means targeting investment properties with a 7.5% cash on cash return is sensible.
Often, cash on cash return adds little value. This is particularly the case in long-term, dynamic or complex projects that involve significant reinvestment.
- A buy to let project involves significant renovations. Properties are then sold on quickly after when the market speaks positively for this type of investment in the given area. Since value is being created dynamically via the renovation of the project, cash on cash return is of little relevance and use.
Cash on cash return provides a static but intuitive measurement of cash flow return relative to initial investments made. It somewhat falls into the same category as cap rate in that it is a simple, rough and ready calculation that can be made with limited information. Obviously, the higher the better. One of the primary considerations is that a particularly low year 1 cash on cash return may result in a loss after tax. Any cash on cash return must be compared to how any income will be taxed.