When shopping for a rental real estate property, how do you know if it’s going to be profitable?
No investment is a “sure thing.” Whether you’re acquiring shares in a business, buying stocks or purchasing a rental property, a certain amount of risk is involved.
This is why careful research and good old-fashioned number crunching are important early steps in the process. This type of due diligence helps you minimize risk, maximize revenue, and make sound financial decisions.
For property investors it’s especially crucial to dig into the data, since so many factors can affect a home’s valuation and appreciation, e.g. location, demographics, employment and so on. The more homework you do on neighborhoods, schools and jobs markets, the better. However, it’s also important to map out your expected annual returns and see whether they’re going to be worth the effort.
Luckily, rental property investors have a number of simple formulas to determine how their ventures will pan out.
One of these is cash on cash return.
What’s the Cash on Cash Return Formula?
Cash on cash return — a.k.a. the equity dividend rate — is a property valuation formula that calculates the ratio of cash earned to cash invested (not including money borrowed to finance the purchase).
Many people use the cash on cash return formula as part of their investment analysis when exploring new properties.
Cash on cash return numbers help determine total return on an investment over time.
How Do You Calculate Cash on Cash Return?
In a nutshell, the cash on cash formula is:
Net Cash Flow / Cash Invested
The “cash invested” number includes all of the capital put into the property purchase —equity invested, closing costs, upfront repairs and loan costs (not including loan interest or payments).
“Net cash flow” includes all cash in hand after expenses are tallied. This number includes monthly rent minus things like utilities, trash collection, landscaping, pest control, etc. When borrowing money, debt costs and interest also need to be subtracted to reach the net cash flow number.
Once you have these two numbers figured out, divide the net cash flow total by the total cash invested. This results in your cash on cash return.
Many people use this ratio to decide how much money to invest in a property or whether to buy a particular property at all.
Why Is Cash on Cash Return So Important?
Most real estate investors adopt the cash on cash return formula as a first step in their purchase decision, and there’s a very good reason why. Cash on cash return can answer a number of key questions about how to proceed with a sale.
For example, it helps you:
- Tally Expenses: Early on, the cash on cash formula encourages investors to think ahead about obvious (and not so obvious) expenses that will be associated with the rental home.
- Choose the Best Property: It provides investors with a quick and easy way to measure the long-term profitability of several rental homes at once, in order to choose the one with the highest potential return.
- Settle on Financing: Cash on cash also clears up crucial profitability questions related to financing, i.e. whether to take out a mortgage and how much, or whether an all-cash purchase is the wiser move.
How to Calculate Cash on Cash Return
Here’s an example of the cash on cash return formula in action:
Say you find a rental home listed at $200,000.
First, figure out how much cash you plan on investing in the property. Say you put in a down payment of 20% ($40,000) and finance the rest. A few up-front repairs, plus your closing costs and loan fees, bring your cash invested number up to $50,000.
Next, you’ll calculate net cash flow.
The home is currently being rented for $1,700 a month and grosses $20,400 annually.
Add up the annual expenses associated with the property, like utilities, internet, anticipated regular repairs, etc. Those expenses total $3,000 per year. Then calculate annual debt costs. A 5% interest loan on $160,000 financed equals $8,000. This means your total annual expenses are $11,000 ($3,000 in expenses plus $8,000 in debt costs).
Your annual net cash flow ($20,400 of gross returns minus $11,000 in expenses) equals $9,400.
In this example, your cash on cash return is 18.8% ($9,400 / $50,000).
This means the property’s annual profit for that year will be 18.8% of the cash initially invested.
Cash on Cash Return Without a Loan
Say you’ve decided to purchase a home without financing. Maybe you want a faster sale, don’t want to deal with a lender, or realize that the interest over time will eat away at your profits.
Here’s a cash on cash calculation roughly similar to the one above, but this time without a loan:
Take the same rental home listed at $200,000 currently renting for $1,700 a month and grossing $20,400 annually. Like the example above, the home generates $3,000 in annual expenses, bringing your net annual income to $17,400. Closing costs and initial repairs increase your cash invested total to $210,000.
The key differences here are that (a) you won’t need to calculate debt costs and (b) your cash invested number will be much higher than if you’d taken out a loan.
In this example without financing, your annual cash on cash return equals 8.2% ($17,400 / $210,000).
You’ll see that the cash on cash return percentage dropped a few percentage points in the no-loan example, but this won’t always happen. Depending on the listing price, monthly rent, mortgage amount, and other factors, the loan version could have the lower number.
Keep in mind that although the all-cash purchase results in a lower ratio, investing with a loan can be a riskier investment since the owner could experience additional costs, reductions in property value, or other issues.
Now that you know how to calculate your property’s value percentage, how do you use that number to weigh your purchase decision?
Cash on Cash vs. Internal Rate of Return
Another real estate valuation metric to consider is Internal Rate of Return (IRR). IRR is defined as the total interest earned on money invested. It differs from the cash on cash metric in several ways, the main difference being that cash on cash measures earnings in annual segments, where IRR calculates total earnings from the entire ownership cycle.
For example, say you plan to hold onto your rental property for 10 years. The rent money you receive in the first year of ownership earns more interest than the final year of rent because it’s earning interest across nine years instead of one.
The IRR formula — ideally conducted through software programs like Microsoft Excel —takes a broad view of how rent income and appreciation income grow to project a property’s total value over time.
What’s a Good Cash on Cash Return?
Opinions vary on what makes an ideal (or acceptable) cash on cash return ratio. Some real estate investors won’t consider a ratio below 8% - 12%, while others have a sweet spot more in the 20% realm.
In truth, what makes a “good” cash on cash return depends on a number of factors, like:
- The Amount You Choose to Finance: The examples above illustrate how the percentage can decrease when you’re financing vs. paying all cash. You might choose to borrow more or less depending on how the ratio matches your goals.
- The Level of Competition: Investors involved in a competitive location might accept lower cash on cash percentages to play in hot markets. In higher value markets, a smaller ratio might yield more cash than a larger ratio would in cheaper markets.
- Rental Strategy and Long-Term Thinking: Are you planning on holding this property for a short while or looking to buy and hold? Longer-term investors might have more flexibility when it comes to ratio numbers.
“Good” vs. “bad” might also come down to a personal assessment based on your investment strategy, appetite for risk, and overall goals. Of course, a “good” cash on cash return could simply be the highest percentage number you register among a group of properties you’re considering: You could use this formula to go with the home that has the higher cash on cash ratio, even if it’s not in the desired 8% - 12% range.
Run the Cash on Cash Formula Every Year
Though the cash on cash return ratio is mostly used to calculate one year of earnings, the formula also helps forecast future profits. For example, if you know rents for your property will increase by a certain percentage five years down the road, or if you know a major repair will eventually be necessary, like a roof or cooling system, you can calculate your returns ahead of time. This is why it’s a good idea to re-run the formula annually.
There are some things cash on cash return can’t factor, like tax benefits or return on investment. Return on investment, for example, can’t be calculated until the property sells.
For this reason—and to make the safest, most educated decision—you’ll want the cash on cash formula to be just one of several property valuation tools you use for your research.
Speaking of tools...
Can we help make your job easier? Roofstock Cloudhouse is a free tool offering comprehensive insight into a home’s rental potential. Simply enter the address of any single-family home in the U.S. and in one click you’ll get a complete forecast of the property’s potential return. This essential tool allows you to view cash flow, cap rate, home appreciation and yield.
Then check out our Top Tips for Analyzing Properties webinar for more strategies on how to evaluate potential investments.