CHAPTER 20

Calculation 14: Cash-on-Cash Return

What It Means

The cash-on-cash return (also called the equity dividend rate) is the ratio between the property’s cash flow in a particular year (usually before taxes) and the amount of the initial capital investment. It is expressed as a percentage.

Although you can calculate the cash-on-cash return based on projections for any future year, investors tend to look at this measurement as it relates to the expected cash flow in the first year of ownership. Since this calculation doesn’t take into account any time value of money, it probably does make sense to measure the cash flow that occurs soonest after you make the investment.

The cash-on-cash return is not a particularly powerful tool, but it has always been popular as a “quick read” on an income property, probably because it allows an easy comparison to other types of investment. For example, you can say, “This property will give me a 6% cash return on my investment in the first year. If I invest in a CD instead, I’ll get only 2%.”

How to Calculate

Cash-on-Cash Return = Annual Cash Flow / Cash Invested

Example

You purchase property with a down payment of $20,000. In the first full year of operation, the property shows a net operating income of $14,000. Your monthly mortgage payment is $1,000. You have no other items that affect your cash flow for that year. What is your cash-on-cash return for year 1?

First, you need to figure out your cash flow. Do you recall how to do that?

Net Operating Income

less Debt Service

less Capital Additions

plus Loan Proceeds

plus Interest Earned

= Cash Flow Before Taxes

You have only two items in this example that you need to consider: NOI and debt service. Your NOI is given as $14,000. Your debt service is the monthly mortgage payment times 12 (1,000 × 12 = 12,000). Your cash flow, therefore, is:

Images

Now you have the two items you need to calculate the cash-on-cash return:

Cash-on-Cash Return = Annual Cash Flow / Cash Invested

Cash-on-Cash Return = 2,000 / 20,000

Cash-on-Cash Return = 10%

Rule of Thumb: Once upon a time, buyers of income property paid a great deal of attention to the cash-on-cash return. It’s easy to calculate and, as mentioned above, allows a quick comparison to an alternative such as a CD or T-bill rate.

You need to know about cash-on-cash because sooner or later someone offering you a property is going to quote this statistic as if you should be impressed. Cash flow is a good thing, and if the property actually has it, fine. Just don’t forget the other, better ways of taking the pulse of an income-property investment, as discussed throughout this book.

Don’t forget, too, that someday you’ll be selling a property and may encounter a buyer who thinks that the cash-on-cash return is really important. If it’s important to your buyer, it’s important to you. It always pays to know your stuff—knowing how to show this basic investment measure may be just what you need to do to close the deal.

Test Your Understanding

A property is fully rented and has four tenants each paying $1,000 per month. Operating expenses are $20,000. Your monthly mortgage payment is $1,800. Assume an allowance for vacancy and credit loss of 2%

1.  You purchase the property with a $50,000 down payment. What is your cash-on-cash return?

2.  The seller takes back a second mortgage for the entire $50,000 down payment. Debt service on this second mortgage equals $453 per month. Now what is your cash-on-cash return?

Answer

1. First calculate your cash flow. Since this problem doesn’t tell you the NOI, start from the top down. The gross scheduled income is provided by four units at $1,000 for 12 months, or $48,000. You expect to lose 2% of that to vacancy and credit, or $960:

Images

The monthly mortgage payment is $1,800, so your annual debt service is $21,600. Subtract the debt service to calculate the cash flow:

Images

Finally, the cash-on-cash:

Cash-on-Cash Return = Annual Cash Flow / Cash Invested

Cash-on-Cash Return = 5,440 / 50,000

Cash-on-Cash Return = 10.88%

2. Two items change in this second scenario. One is the addition of a second mortgage whose debt service affects your cash flow:

Images

The second item to change is the amount of cash invested, which is now zero.

Cash-on-Cash Return = Annual Cash Flow / Cash Invested

Something is wrong with this picture. Anything divided by 0 equals infinity. Our cash flow doesn’t matter; even if it were one penny, we would have the same infinite cash-on-cash return.

What’s this all about? You have an income-property investment with no cash invested. Why can’t you figure out this rate of return—or any other, for that matter?

You can’t calculate the return because there is no such thing as a zero-cash-down investment. If you invest nothing, then you have no investment. You have nothing at risk. You could rephrase question #2 to ask, “What’s the return on my investment if I make no investment?”

Rule of Thumb: Transactions with no money down do occur, although this writer suspects that successful deals of this kind are probably far less common than the purveyors of get-rich-quick tapes and seminars would have you believe. There are some practical considerations that argue against the likelihood of success:

1.  To finance 100% of an income-property purchase means you’re going to have more debt service than a typical buyer. This in turn means that you have a much greater likelihood of experiencing negative cash flow. Instead of reaching into your pocket one time to ante up the down payment, you may be reaching in every month to make up the difference between cash inflow and cash outflow.

2.  The cost of this additional financing is likely to be high. Loaning the “down payment” component is a high-risk proposition. A third-party lender would expect a high rate and a short repayment term, both of which would be likely to suck the life out of your cash flow.

3.  Why would a seller take back all the secondary financing if you don’t put in your own cash? Maybe the property is difficult to sell; that won’t change after you buy it, except that now it will be your problem. Maybe the seller has convinced you to agree to an inflated price, so the proceeds from the secondary financing are just gravy. Study this book and that won’t happen to you.

If all the stars are lined up just right, a no-money-down deal can work out beneficially, but don’t expect that to happen routinely.

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