Passive investors in crowdfunded real estate transactions may not be familiar with some of the various ways that return on investment can be calculated in the real estate world. Here we explore one of the most common measures, the “cash-on-cash” return.
Cash-on-cash (sometimes called the equity dividend rate) is one of the most common return formats used in the real estate industry. It is a ratio (usually converted to a percentage) that is derived by dividing cash flow (before tax) by the amount of equity initially invested.
The cash flow figure equals the net operating income of the property – the gross rental income less the usual operating expenses – minus the debt service on any mortgages to which the property is (or will be) subject. That number is then divided by the equity investment in order to get a measure of the “return on equity,” or cash-on-cash return. A simple example might be as follows:
Effective gross income $180,000
Less: operating expenses ($70,000)
Net operating income $110,000
Total investment (all-cash) $1,000,000
Cash-on-cash return = $110,000 = 11.0%
The cash-on-cash figure doesn’t take into account any income tax effects, resale implications (including changes in property value), future cash flows, or reductions in loan principal. It does, however, give a good feel for the immediate and ongoing periodic return that a cash flow investor can expect.
The cash-on-cash figure can also show the effects of leverage – using a mortgage loan to finance part of the property’s purchase price. Let’s assume now that in the above example $800,000 of the total purchase price is financed by a mortgage loan – so that the investor is only paying $200,000 cash for the same property. Although this will result in debt repayment expenses (interest and, oftentimes, principal amortization), the much lesser equity investment required often makes this additional expense worthwhile. Let’s look at the same property with leverage in place, assuming an 8% interest-only loan:
Net operating income $110,000
Less: debt service (8%) ($64,000)
Net cash flow $46,000
Cash-on-cash return = $46,000 = 23.0%
Our cash-on-cash return would thus more than double if this mortgage loan were to be used to finance the greater part of the property’s purchase price. Loans bring with them risks, of course – any decrease in the property’s projected net operating income will be borne entirely by the owner, since the bank must be paid back in any event. Yet this cash-on-cash return analysis shows how leverage can also greatly increase the return on equity, and thus the proportionate cash flow returns to the investor, if the interest rate on the loan offers favorable financial leverage to the person making the equity investment.
There are other measures that may be needed to decide whether an investment should be purchased; investors need to consider income taxes, riskiness, whether more or less money should be borrowed, and possible alternative means of financing. A potential real estate investment requires a sophisticated level of in-depth analysis. The cash-on-cash return measure remains a basic and important yardstick, however, in indicating whether an investment might be a good one.
Source: Realty Mogul