Investing in real estate can be a great way to achieve financial freedom and to create wealth that can benefit your family for generations. While it’s true that investing in real estate can help create an indestructible source of income, many investors starting out in real estate make one critical mistake. By thinking that they can buy any property, and once they find a renter the math on the deal will eventually work out.
This is a mistake you can’t simply afford to make as a real estate investor.
Not every property will be a good deal for you. The last thing you want is to spend your hard-earned money on a property that drains your bank account every month. One crucial metric to evaluate the profitability of a real estate investment is the Cash-on-Cash return(CoC). Cash on Cash return is an invaluable metric you can use to get a clear picture of cash flow generated by your property and gauge the efficiency of cash used in the purchase.
While calculating Cash-on-Cash return can help you make sound investment decisions, making a positive return on any investment is never guaranteed. You should never rely on one metric alone to make investment decisions.
Understanding Cash on Cash Return
Cash on Cash return is a financial metric used to assess the profitability of an investment property. It measures the annual pre-tax cash flow generated by a property relative to the total cash investment made by the investor. In simple terms, CoC return indicates the percentage return on the cash invested in the property.
Cash on Cash Formula
Cash on Cash Return = (Annual Pre-Tax Cash Flow / Total Cash Investment) x 100
To calculate Cash on Cash return, you need to gather the following information:
1. Annual Pre-Tax Cash Flow: This represents the net operating income (NOI) generated by the property after deducting operating expenses, such as property taxes, insurance, maintenance, and property management fees. The annual cash flow should be calculated before considering income tax expenses.
2. Total Cash Investment: This includes the total amount of cash you have invested in the property, including the down payment, closing costs, and any renovation or improvement expenses.
Example Calculation:
Let’s consider an example to illustrate the calculation of Cash on Cash return:
– Annual Pre-Tax Cash Flow: $20,000
– Total Cash Investment: $200,000
Using the formula mentioned earlier:
Cash on Cash Return = ($20,000 / $200,000) x 100 = 10%
Interpreting Cash on Cash Return
The resulting percentage represents the Cash on Cash return for your investment property. In the example above, the CoC return is 10%, indicating that for every dollar invested, you are earning a 10 cent return annually. A higher CoC return signifies a more profitable investment.
Significance of Cash on Cash Return
1. Evaluating Investment Opportunities: Cash on Cash return enables investors to compare multiple investment properties and assess which ones are likely to generate higher returns. By analyzing the CoC returns of different properties, you can make informed decisions about where to invest your capital.
2. Assessing Risk and Profitability: Cash on Cash return also helps in gauging the risk associated with an investment. A higher CoC return suggests a more favorable risk-to-reward ratio, as the property is generating greater cash flow relative to the invested capital.
3. Making Informed Investment Decisions: By calculating Cash on Cash return, investors can estimate the potential income generated by an investment property and determine if it aligns with their financial goals. It helps to set realistic expectations and make informed investment decisions.
Wrapping Up
Calculating Cash on Cash return is an essential step in evaluating the profitability of real estate investments. By considering the annual cash flow generated by the property relative to the initial investment, this metric provides investors with a clear understanding of the returns they can expect. Armed with this knowledge, investors can make informed decisions, compare investment opportunities, and assess risk and profitability effectively. Remember, understanding the nuances of Cash on Cash return can significantly enhance your ability to build a successful real estate portfolio.