One of the fundamental metrics for analyzing a potential commercial real estate investment is the “cash-on-cash” return it may generate. The cash-on-cash return rate indicates how much cash may be earned on a property investment relative to the amount of cash initially invested. It may be a good screening tool to use when comparing investments based on their first-year cash flows versus the amount invested.
In the cash-on-cash equation, the pretax cash flow is based on the annual gross income (i.e., gross rent) minus operating expenses such as maintenance, insurance and property taxes minus mortgage payments. Total cash invested encompasses all out-of-pocket capital and may include down payments, closing costs and improvements, and repairs to the property but does not include borrowed money.
Let’s say a rental property is purchased for $100,000. The investor makes a 20% down payment ($20,000) and pays $4,000 in closing costs for a total of $24,000 invested in cash. The annual rental revenue for the example property is $6,000, property expenses $700, and mortgage payment $2,800. Given these parameters, the cash-on-cash return for the property is 10.4% (($6,000-$700-$2,800)/$24,000).
What is a good cash-on-cash return?
Disregarding the risk profile of an investment, the higher this metric is, the better. But the more important question for the individual investor is what percentage of cash-on-cash returns make an investment worthwhile? A savvy investor will compare the cash-on-cash return they can generate on a property to the returns they could potentially make by investing in the stock market, a real estate investment trust (REIT), a debt investment or other options. In addition, they will evaluate the risk profile of each investment. Typically, a prospective higher cash-on-cash return means that the investment’s risk profile is higher (meaning there is a higher likelihood you could lose money). If you are thinking about investing in real estate and also managing the property, there is also the cost of time and energy in managing the investment to consider. Ultimately, the optimal cash-on-cash return will depend on an individual’s appetite for risk, alternative investment opportunities and tolerance for spending time and energy managing an investment.
Is cash-on-cash a reliable metric?
Cash-on-cash return should be understood by investors and used as a metric when analyzing real estate investment opportunities, but it has its limitations. Namely, it may not be the most reliable metric for determining profitability for all types of real estate deals, particularly value-add opportunities, given the nature of the timing of net income generation and when proceeds are distributed. For example, often in value-add deals (i.e., renovating a multi-family property and renting out the refurbished units) cashflow may be severely limited in the early years thus making the cash-on-cash return miniscule if not nonexistent. To remedy this and reach the projected cash-on-cash returns advertised to investors, sponsors may supplement dividend payments by using loan proceeds or capital raised instead of actual cash flow generated by the property. In such cases, the cash-on-cash return may not be painting an accurate picture of the financial performance of the property.
To sum it up
Metrics, like cash-on-cash returns, are valuable tools for analyses but can be manipulated just like any other estimates, and the actual outcomes may differ greatly from projections. Instead of relying only on one number to deem an investment opportunity as worthwhile, consider factors like the size of the project, how long the holding period is, what potential risks may occur and the actual amount of profit that will be realized. Used alongside the cap rate, internal rate of return (IRR) and other performance indicators, cash-on-cash may help an investor make a more informed decision about an investment opportunity.
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The views and opinions expressed in this commentary reflect Modiv Inc.’s (together with its affiliates, “Modiv”) beliefs and observations in commercial real estate as of the date of publication from sources believed by Modiv to be reliable and are subject to change. Modiv undertakes no responsibility to advise you of any changes in the views expressed herein. No representations are made as to the accuracy of such observations and assumptions and there can be no assurances that actual events will not differ materially from those assumed. The forward-looking statements in this paper are based on Modiv’s current expectations, estimates, forecasts and projections, and are not guarantees of future performance. Actual results may differ materially from those expressed in these forward-looking statements, and you should not place undue reliance on any such statements. These materials are provided for informational purposes only, and under no circumstances may any information contained herein be construed as investment advice or as an offer to sell or a solicitation of an offer to buy an interest in any Modiv program or offering. Alternative investments, such as investments in real estate, can be highly illiquid, are speculative, may not be suitable for all investors, and there is no guarantee that distributions will be paid.