There are several metrics and factors you want to consider when evaluating a rental property for profitability. Location is always critical along with matching the property type to the location. That’s one reason for zoning regulations, so that a single family home isn’t wedged in-between two skyscrapers. You also want to know what tenants you are targeting. It’s almost never a good strategy to have the most expensive house in the neighborhood because the value (and rents) appreciates more slowly. However, having one of the least expensive properties in the neighborhood can benefit from faster value appreciation. Other rental analysis includes Rental Income and Cash Flow, Vacancy and Occupancy Rates, Cap Rate, and Comparative Market Analysis. Here we take a closer look at Cash on Cash Return.
Cash on Cash Calculation
The cash on cash return is used to calculate the return on investment of an income property. It’s different from the cap rate metric because cash on cash takes into consideration the method of financing. Specifically, the cash on cash return only takes into account the actual cash invested in the property’s purchase (but accounts for debt service).
So, if you purchase a property using 80% borrowed money and 20% cash, the cash on cash return metric only uses the 20% cash as the denominator.
The formula for calculating the cash on cash return is:
Cash on Cash Return = (Annual Pre-tax Cash Flow ÷ Actual Cash Invested) X 100
Calculating the Pre-tax cash flow:
Annual Gross Rents + Other Income – Vacancy – Operating Expenses – Debt Service
The total cash investment is all the cash that you pay out to make your rental property operational. It does not include borrowed money. Cash investment typically includes the amount of money to pay to purchase it, closing costs, rehab costs, and loan fees. Be careful with loan fees. Include these if you paid them in cash. Exclude them if the fees were rolled into the loan. The cash on cash return only includes cash you pay out.
The cash on cash return, which is also expressed as a percentage, represents that amount of money that you will make each year out of the total amount of cash that you’ve invested in the property. The cash-on-cash return is a great metric and is widely used throughout the real estate industry. The primary reason for this is due to the metric’s simplicity in calculating the percentage return.
The cash-on-cash return specifically drills down into the return based on the capital invested. It does so by only considering returns that are driven by the property’s net cash flow. It is an essential part to value investing because it does not take into account asset appreciation.
Other Metrics Matter
Run various scenarios. Another important step in determining a realistic property value is running rental forecasts. Recently, rents have been steadily increasing and vacancies are very low. But that doesn’t always happen long term. Would your investment still cash flow positive if rents begin decreasing 5% a year and continue to decrease for 5 years? Or will higher mortgage interest rates continue driving vacancy rates lower and rents higher? Always run a bearish case, realistic case, and bullish case scenario at a minimum.
Also run different investment scenarios involving taxes and depreciation. What happens if taxes go up or down? What happens if the depreciation formula changes? If your cash flow is barely positive, what happens if you have to pay depreciation recovery when you sell the property?
Value appreciation is nice but it’s secondary to income. Housing bubbles (and collapses) happen when investors move away from the income component of the property and just focus on potential property appreciation. A bad sign of over-dependence on appreciation is when a property has negative cash flow. It becomes a “bet” that you’ll make a profit by selling in a year or two. You’re a speculator. When speculators exit the market it causes a domino effect driving down prices for you, “buy and hold” investors, and the entire neighborhood. The time for speculation was when there was a glut of foreclosures on the market. Today, there is no real value for real estate if it does not generate income.