Analyzing a Property: Cash on Cash Return
One of the simplest ways of calculating an investments return. It may be one of the most important to your pocketbook. The cash on cash return is the calculation that compares the actual dollars invested with the actual dollars returned within the first 12-month period. If you have $1000 and invest it all and receive $50 as a return on your investment at the end of the year, that is a 5% cash on cash return.
When you invest in a blue chip stock that generally pays 3% dividend, you can bet you are going to get about 3% on your investment - a la Coke (KO). They have been around for years and have history to prove what their dividends typically are.
Real estate investing on the other hand is mad science.
Going into a real estate transaction, you are estimating what it is going to rent for and what your expenses will be. The more scale you have 25, 50, 100+ units, you can average out the maintenance, see the actual financials and determine roughly what the annual operating expenses will be. Not so with a single family. A single family investment can be a smooth operator with minimal maintenance expenses for some years. Others, you could have a rotted out mainline that costs $15,000 to replace. Oops, there goes that years cash flows.
If you are investing in a condo, single family home or small multifamily, this is where your inspection comes into play. You can, with relative certainty, estimate your taxes, insurance, utilities and other expenses. Maintenance will be determined by how well you manage the property, how old the unit is and how much deferred maintenance is in the property. I can promise you one thing, your annual maintenance expenses will NOT be $0.
Cash on cash return is calculated in the first year of the investment. Cash invested vs. Cash returned.
Purchase Price: $250,000
Closing Costs: $5,000
Total Initial Investment: $67,500
Gross Rents: $1,750/Month or $21,000 total
Actual Operating Expenses: $525 or $6,300 total
Debt Service: (30 year amortized loan at 4.5%): $950/Month or $11,400
Total Expenses: $1,475 or $17,700
Annual Net Operating Income: $3,300
Cash on Cash Return Calculation:
$3,300/$67,500 = 4.9% Cash on Cash return or $/$%
So here, you have to ask yourself is the risk worth the reward? Would you rather just invest in a dividend producing stock? Possibly. This return calculation is not factoring in the appreciation of the property, the principal paydown that occured and the tax benefits of investment real estate depreciation. This return simply tells you the return rate based on the cash outlay vs the cash that came in year 1.
Cash flow is king in real estate. The other benefits of real estate when you are just starting out are secondary.