In real estate investing, the cash-on-cash return[1] is the ratio of annual before-tax cash flow to the total amount of cash invested, expressed as a percentage.
The cash-on-cash return, or "cash yield", is often used to evaluate the cash flow from income-producing assets, such as a rental property.
Generally considered a napkin test to quickly determine if the asset qualifies for further review and analysis, cash on cash analyses are often used by investors looking for properties where cash flow is paramount, however, some use it to determine if a property is undervalued, indicating instant equity in a property.[2]
Example
Suppose an investor purchases a $1,200,000 apartment complex with a $300,000 down payment. Each month, the cash flow from rentals, less expenses, is $5,000. Over the course of a year, the before-tax income would be $5,000 × 12 = $60,000, so the NOI (Net Operating Income)-on-cash return would be
.
However, because the investor used debt to service a portion of the asset, they are required to make debt service payments and principal repayments in this scenario (I.E. mortgage payments). Because of this, the Cash-on-Cash return would be a lower figure which would be determined by dividing the NOI after all mortgage payment expenses were deducted from it, by the total cash invested.
For example: If the investor made total mortgage payments (principal+interest) of $2,000 a month in this scenario, then the Cash-on-Cash return on the investment would be as follows:
$2,000 x 12 = $24,000
$60,000 - $24,000 = $36,000
.
Limitations
Because the calculation is based solely on before-tax cash flow relative to the amount of cash invested, it cannot take into account an individual investor's tax situation, the particulars of which may influence the desirability of the investment. However the investor can usually deduct enough Capital Cost Allowance to defer the taxes for a long time.
The formula does not take into account any appreciation or depreciation. When some cash is a return of capital (ROC) it will falsely indicate a higher return, because ROC is not income.
It does not account for other risks associated with the underlying property.
It is essentially a simple interest calculation and ignores the effect of compounding interest. The implication for investors is that an investment with a lower nominal rate of compound interest may be superior, in the long run, to an investment with a higher cash-on-cash return.
It is possible to perform an after-tax Cash on Cash calculation, but accurate depictions of your adjusted taxable income are needed to correctly address how much tax payment is being saved through depreciation and other losses.
Cash Flow Analysis
Cash flows are often transformed into metrics that provide information,[3] for example, about a company's value and position:
to determine the profitability or value of a project. The timing of cash inflows and outflows in projects is used as input data in financial models such as the internal rate of return and net present value.[4]
to identify liquidity problems of the business. Profitability does not necessarily mean liquidity. A company can go bankrupt due to a lack of cash, even while being profitable.
as an alternative measure of a company’s profit, when it is considered that accrual principles do not reflect economic reality. For example, a company may be theoretically profitable but generate little operating cash flow (as in the case of a company that barters its products instead of selling them for cash). In this case, the company may receive additional operating cash flow through issuing shares or attracting additional debt financing.[5]
Cash flow can be used to assess the “quality” of income earned on an accrual basis. When net income consists of significant non-cash items, it is considered low-quality.[6]
to assess risks within a financial product, for example, matching cash needs, assessing default risk, reinvestment requirements, etc.
Cash income is a widely used metric in real estate, showing the percentage return on actual cash invested in property. Although it is useful for analyzing profitability and comparing investment opportunities, it should be used together with other indicators such as internal rate of return (IRR), net operating income (NOI), and capitalization rate to obtain a complete picture of investment performance.[7]
The concept of “cash flow” is generally based on accounting standards for cash flow statements.[8][9] This term is flexible and can refer to time intervals covering both the past and the future. It may relate to the total of all involved flows or to a subset thereof.
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