“Cash on Cash” is a ratio often used to evaluate cash flow from income-producing assets. It's typically used as a quick litmus test to determine if a given real estate investment qualifies for further review and analysis.
It's the ratio of annual before tax cash flow to the total amount of cash invested, expressed as a percentage. In its simplest form it is calculated as:
COCR = Annual Before Tax Cash Flow / Cash Invested
Let’s look at a detailed example. Suppose an investor purchases a $1,200,000 apartment complex and spends $10,000 in due diligence and closing costs. The investor is able to secure a 30-year mortgage of $900,000 with a 5.00% interest rate. The annual payment due on this mortgage is $58,600 (principal and interest). The apartment complex generates net operating income (rental income less operating expenses, such as property taxes and repairs) each year, to the tune of $84,000.
To calculate the COCR in the above example, you must first determine the actual cash invested. In this case $310,000 ($1,200,000 price + $10,000 costs - $900,000 mortgage financing). You can then calculate the return as follows:
Annual net operating income
less anual debt payment
before tax cash flow
Divided by cash invested
Cash on Cash return
As is often the case with financial ratios, cash on cash return can be very useful when applied correctly, but it has its limitations. It provides a very useful way for investors to estimate the return on their invested cash, taking into account the ability to leverage their investment with debt financing. While the “Cap Rate” is useful for evaluating a real estate asset’s price relative to its operating income, the cash on cash return ratio helps to evaluate the investment with all of its financing components factored in.
However, the calculation of cash on cash return is based on before tax cash flow from the investment, and every investor has unique tax circumstances. Some of the cash flow from the investment may be treated as return of capital, which tends to make this calculation overstate the investor’s rate of return. It also does not take into account the potential tax benefits of depreciation or appreciation in asset value. But if you need a quick, back of the napkin calculation to determine cash flow from an income-producing investment, the cash on cash return ratio will help you determine if an investment warrants more analysis.
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Hypothetical example(s) are for illustrative purposes only and are not intended to represent the past or future performance of any specific investment.
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