Learning to Learn and Valuation Metrics: Installment 2: Cash-on-Cash Return
Cash on Cash Return
Cash on Cash Return is a valuable metric in real estate investing, offering a straightforward and practical measure of an investment's profitability. It is particularly important for investors who are focused on the income-producing potential of a property. This metric calculates the cash income earned on the cash invested in a property and is expressed as a percentage. The formula for Cash on Cash Return is:
This metric answers questions such as; If I have $X in closing cost and $X in initial repairs, what kind of return can I expect given my best estimation of expenses over a given time period. I find that Cash on Cash has the most meaning if calculated and compared year to year. For example, I would expect COC to be lowest in the first year and greater each year as investment decreases and profits (hopefully) increase.
Cash on Cash Return is important:
It is relatively simple and intuitive: It provides an easy-to-understand measure of the income generated on the actual cash invested, making it a straightforward tool for investors to assess the immediate yield of a property.
It allows assessment the impact of leverage: Because COC includes in its calculation the cost of financing (unlike Cap Rate), it allows one to quantify the impact of various financing strategies on return over time. For example, an interest only loan would have a higher first year COC than a traditional loan in which equity is paid from the beginning, assuming all other financing variables were similar.
It assesses performance over time: Tracking COC annually gives an indication of how the property is performing year to year.
It evaluates cash flow in a realistic way: Because it focuses on actual cash flow generated (rather than presuming future market variables) it may allow investors who focus on cash flow a more realistic assessment of predicted vs actual performance.
It may inform refinancing decisions: When considering whether to refinance a property, investors can use COC to determine the effect of changing loan terms on return on investment.
While valuable, Cash on Cash Return should not be the sole metric in investment decisions. It doesn't account for property appreciation/depreciation, tax implications, or mortgage principal payments (the equity that builds over time or the time value of money). Investors should use it alongside other metrics like Cap Rate, IRR and others for a comprehensive analysis of the property's potential.
