Cash-on-cash return is, arguably, one of the most important numbers to calculate prior to buying a rental property. Actually, scratch that. It's one of the most important percentages to know prior to closing on any type of deal. So if you ask me, "Is it important to know the cash-on-cash return on rental homes?" guess what my answer will be. HECK YES!
If this is the first time you hear about cash-on-cash return, you're in for a treat. Knowing this ratio totally changed the way I distinguish a good deal from a gold mine project.
Let's start with the basics. What's cash-on-cash return? Cash-on-cash return is the ratio of annual before-tax cash flow to the total amount of cash invested. If you want to see it expressed as a percentage, just multiply by 100. This is what the ratio would look like:
Before we start analyzing deals let's define these two other terms:
ANNUAL BEFORE-TAX CASH FLOW is equal to "Gross rental income" (how much tenants pay you each year) + "Other income" (renting out the shed, charging fee for laundry or pets, etc) - "Vacancy rate" (amount of rental income you expect to not receive due to units not being rented out) - "Operating expenses" (insurance, taxes, property management, HOA, marketing, ongoing repairs, etc) - "Annual debt service" (monthly mortgage payments, think principal and interest)
TOTAL CASH INVESTED is equal to "Down payment" (how much money did you put "down" to buy the property) + "Closing costs" (loan origination fees, appraisal feeds, title searches, etc) + "Repairs completed before renting out units" (if you rehabbed the house before renting it, put how much you spent here)
Let me illustrate how this little number can help you distinguish a good deal from a gold mine.
Let's analyze two basic deals:
Deal 1
Description: Duplex with 4 bedrooms total. Working-class neighborhood, B- schools. Monthly rent is $2500 total. Property is town over so you will forego property management.
| Annual Before-Tax Cash Flow | |
| Gross Rental Income | $30,000 |
| Other Income | $0 |
|
Operating Expenses |
$7,000 (Flood insurance, property taxes & repairs) |
| Annual Debt Service | $11,400 |
| Vacancy | 0 (qualified renters lined up) |
| Annual Before-Tax Cash Flow Total | $11,600 |
| Total Cash Invested | |
| Down Payment (15%) | $58,500 |
| Closing Costs (paid by seller) | $0 |
|
Pre-rental rehab (cosmetic finishes) |
$5000 |
|
Total Cash Invested Total |
$63,500 |
"Annual before-tax cash flow" / "Total cash invested" = Cash on cash ROI
CASH ON CASH ROI = .183 (for a percentage, x 100, to get 18.3%)
18% is phenomenal! This is a very good deal.
Deal 2
Description: 3-bedroom single-family home. Wealthy neighborhood, great schools. Monthly rent is $5500. Property is 250 miles away so you will need property management.
| Annual Before-Tax Cash Flow | |
| Gross Rental Income | $66000 |
| Other Income ($50 per mo. for pets) | $600 |
|
Operating Expenses |
$9800 (taxes, property management, insurance) |
| Annual Debt Service | $45,600 |
| Vacancy | 0 (qualified renters lined up) |
| Annual Before-Tax Cash Flow Total | $11,200 |
| Total Cash Invested | |
| Down Payment (3.5% FHA loan) | $29,750 |
| Closing Costs | $6,000 |
|
Pre-rental rehab (cosmetic finishes) |
$2,000 |
|
Total Cash Invested Total |
$37,750 |
"Annual before-tax cash flow" / "Total cash invested" = Cash on cash ROI
CASH ON CASH ROI = .297 (for a percentage, x 100, to get 29.7%)
29.7% is a GOLD MINE!
So what did we learn? Allthough the duplex gives you a slightly larger pre-tax cash flow, the results show that the single-family will yield a higher return on your dollar. For every $1 invested in that home, you will get $1.30 back. Investing in mutual funds won't even get you that much!
Cash-on-cash ROI is invaluable for evaluating the potential of deals that are intended to be held for the long term, hence why I use it when analyzing rental properties. If cash flow is the key source of income rather than resale, you'll want to know the cash-on-cash return of the deal.
While cash-on-cash return is great to know, it's not the only thing you should calculate when analyzing a deal. Be aware that cash-on-cash return is only looking at how much money you put into the deal and how much money comes out--it does not include other factors that may affect the health of your investment, like market trends, changes in zoning, falling occupancy rates, or any potential change in a property’s value. Moreover, most investors agree that cash-on-cash return should only be used in the first year of ownership. Keeping all this in mind, you should still calculate the cash-on-cash return of a deal --especially if it's a rental property. In addition to helping you see how good of a money-making machine the property will be, it'll also separate the gold mine deals from the regular ol' "good deals" amateur investors will be jumping on.
FREE REPORT ALERT
FREE REPORT ALERT
