Investing in real estate isn’t just a matter of making money; it’s about making enough money that your investment of time, money, and resources is worth it. This is where knowing your cash-on-cash return is useful. Of course, like many metrics of evaluation use in real estate investment, cash-on-cash return is part of a constellation of tools and strategies at your disposal.
What is a cash-on-cash return?
Cash-on-cash return (CCR) is the measure of yearly revenue generated by your investment dollars expressed as a percentage. In other words, CCR tells you how much money your money is making you. It’s unlike return on investment (ROI), which looks at the return on the entire investment, including the property’s cost and everything from taxes and debt to repairs and fees.
How do I calculate cash-on-cash return?
Cash-on-cash return is Net operating income (NOI) / Total cash invested x 100%
Your NOI is the rental profit you’ve made before taxes minus the operating expenses. Your total cash invested is the sum of your down payment and closing costs.
So, let’s say you have a $100,000 investment. Your down payment plus the closing costs add up to $25,000 total cash invested. If your NOI is $3,000 per year, then your CCR equation would look like this:
($3,000 ÷ $25,000) x 100% = 12% CCR
How do I calculate cash-on-cash return if I buy the property in full?
The numbers look different if you bought the property outright. Then your cash in would be $105,000, which is the sum of the full value of the property and the closing costs. Your NOI would be higher because your operating expenses wouldn’t include debt service expenses.
In the scenario above, let’s say your NOI is $9,500. If that were the case, your CCR equation would look like this:
($9,500 ÷ $105,000) x 100% = 9.05% CCR
Your CCR will probably fluctuate over the life of your investment because you’re likely going to have large expenses, such as replacing your HVAC. \
What’s a good cash-on-cash return?
Your overall ROI will be affected by potential appreciation and depreciation over time. But given that the average stock market return is roughly 8%, the above CCRs are pretty good!
Although it takes so much effort to find and buy real estate, manage it, and rehab it, you’ll want to increase your CCR to make it worth it. That’s why investment strategies like wholesaling, rehabbing, flipping, and buy, rehab, rent, refinance, repeat (BRRR) are so popular.
How can I get a better cash-on-cash return?
To get a better CCR, consider a Class C or Class D asset. These properties have lower acquisition costs. Acquisition cost refers to the combined cost an investor notes on their books for real estate after adjusting for discounts, incentives, closing costs, and other indispensable expenses, but before sales tax. Acquisition costs can also describe the expenses associated with finding a new tenant.
Given the lower acquisition costs for Class C and D properties, your rent can easily be greater than 1%, which will also help you build equity faster, providing increased ammunition if you want to finance other investment strategies. Yes, these properties will require more work and will be more difficult, but a property manager can also take care of that for you.
What’s a Class C property, and why will it improve my cash-on-cash return?
Class C properties:
- Tend to be older properties that were built 30+ years ago.
- Require significant rehab.
- Are found in older or declining neighborhoods where there’s a greater mix of renters and homeowners.
- Are in areas where the crime rate is often higher, although not widespread.
- The school district isn’t great.
- The potential for appreciation is very low or not a viable consideration.
- The tenant class is blue-collar and earns hourly wages.
- There will be potentially more vacancies because qualified tenants are more challenging to find.
- Tend to require more maintenance.
- Experience increased turnovers.
- Have an increased possibility of eviction.
- It can be bought for less, making it easier to set rent greater than 1% of the acquisition cost. This means cash flow will be higher, resulting in a greater CCR.
What’s a Class D property, and why will it improve my cash-on-cash return?
Class D properties:
- Are old, run-down, and require many repairs.
- They’re found in declining neighborhoods with high crime and poorly ranked school districts.
- The tenants have low income and bad credit.
- Rent collection may be challenging.
- Evictions are expected.
- Appreciation is not to be expected.
- These properties provide the highest CCR because they’re so inexpensive, making average rent significantly greater than 1% of the acquisition cost.
How does cash-on-cash return compare to dividend yields for REITs?
Real estate investment trusts (REITs) provide the financial backing for or own revenue-generating real estate in various niches. Many of them are traded on major stock exchanges, just like stocks. REITs pay out dividends, which are a portion of a company’s income distributed to shareholders. Some investors compare their CCR goals with REIT dividend yields, a metric used to evaluate REIT health. Since it’s so labor-intensive to invest in real estate, a REIT delivers better returns than the property isn’t worth the investment.
What other metrics should I compare cash-on-cash return to?
To get a better picture of whether or not you should invest in a property, also consult the following:
- Capitalization rate (cap rate)
- Internal rate of return (IRR)
- Cash flow
- Potential appreciation of the property
- Individual risks
- Management requirements
What is cap rate?
Cap rate is the percentage of your investment you earn back every year. The formula is the quotient of your net operating income divided by your total initial investment multiplied by 100% so that your answer is expressed as a percentage.
So, if your net operating income is $5,000 and your total investment was $40,000, your cap rate would be 12.5%.
That’s (5,000 ÷ 40,000) x 100% = 0.125.
A cap rate of at least 4% is considered good. Like your CCR, it will be even higher if you invest in a Class C or Class D property.
What is internal rate of return?
IRR is the pace at which your investment pays for itself. It’s often used in conjunction with a hurdle rate, which is the minimum rate of return deemed acceptable by an investor or manager.
IRR is calculated using spreadsheet software or a financial calculator because the formula is so complex we won’t get into the math here. Instead, we’ll focus on when IRR is most useful, which is when you’re trying to communicate or discern information about an investment quickly.
If you know the IRR is 20% and your hurdle rate is 15%, then you know you’re expecting 5% more return on your investment than your minimum threshold allows.
The downside is that the IRR doesn’t tell you how much money you’ll make. So, it’s unclear if it’s 5% of $6,000 or $6.
What is cash flow?
Cash flow is the amount of income you make off your investment, minus general expenses, taxes, interest, etc.
How do I calculate the potential appreciation of a property?
Using your property’s current value and its previous value, you can calculate how much the price has appreciated as either a dollar amount or a percentage. To see what the appreciation is as a dollar amount, just subtract the initial value from the current value. To express gratitude as a percentage, divide the price difference by the initial cost and multiply by 100%.
If the home was $100,000 initially and is now $200,000, then subtracting the former from the latter will tell you that the property has appreciated by $100,000. To express that as a percentage, divide $100,000 by $200,000 to get .5 and multiply that by 100% to discover that it appreciated by 50%.
However, keep in mind that potential appreciation will be less in Class C and Class D properties if it exists at all.
What are individual risks of investing in real estate?
Some risks to watch out for when investing in real estate include:
- Buying a bad property.
- Getting bad tenants.
- Being sued.
- The value of your property decreases because your market declines.
- A poorly chosen location.
- Being illiquid in the face of adversity.
In many cases, however, you can reduce the likelihood of these risks by conducting due diligence.
What are the management requirements for investing in real estate?
It takes significant time, skill, and resources to run an investment property, so there’s a lot to consider when weighing the pros and cons of using a property manager. This is especially the case if you want to increase your CCR by investing in Class C or D properties. A property management company is useful because it allows your real estate investment to be a form of passive income. Otherwise, you’ll have to:
- Find tenants
- Screen tenants
- Collect security deposits and rent
- Conduct maintenance, repairs, and unit prep between tenants
- Respond to emergencies
- Evict tenants if need be
- Keep up to date with and follow local ordinances
- And more
You want your investment dollars to deliver you the most bang for your buck. That means using several metrics to study your potential investment, considering Class C or D properties, or considering other investment strategies like BRRR. You want your investment to be worth it, so make sure you’re getting more CCR than if you invest in a REIT and, if need be, work with a property management company to ensure your investment is a passive one.