Understanding how cash on cash return works for real estate is vital when evaluating real estate investment transactions. Before plunging directly into specific examples of cash on cash return scenarios, it’s important to have a firm grasp of what the term exactly means. Starting with a basic formula we can start to see how this calculation is made:
cash on cash return = annual before tax cash flow ÷ total cash invested
As shown in the formula above, cash on cash return is a basic measurement of investment performance which is calculated by taking the cash flow of the property before taxes and dividing it by the initial equity investment. The before tax cash flow figure for each year is based upon the “real estate proforma” and the initial investment of equity is the total purchase price minus any loan proceeds.
Example of cash on cash return
Now for a simple and basic example of how this works. Let’s suppose that you are appraising a duplex that has a projected year 1 before tax cash flow of $20,000. Let’s also conclude that the settled upon purchase price of the property is $400,000 and you can secure a loan for $300,000 which is 75% loan to value. What would be the cash on cash return for one year?
$20,000 ÷ $100,000 = 0.20 = 20%
Now, this calculation is rather simple, your cash on cash return for one year comes down to the one year before tax cash flow divided by your total out of pocket cost. This equates to precisely 20%. This calculation is very basic but allows the investor to understand that their one year return on investment is 20%. Of course all of this is based strictly upon the proper calculations of cash flow projection and the accuracy of your intial equity investment figure.
The cash on cash return calculation is a simple way of measuring investment performance and can be a great way to quickly filter through several different potential investment property opportunities. It is however a very limited form of calculating finite details of investment and predicting future growth or decline.
Discounted Cash Flow Analysis
The simple measurement of cash on cash return to gauge investment performance works as a reasonable good starting point in a proerty evaluation, however when your interest in the property begins to get more serious, it would be wise to conduct a further and more detailed analysis.
A discounter cash flow analysis factors in important elements such as time value of money to place a value on a real estate asset. When considering a time period that extends out over several years, a discounted cash flow analysis estimates future potential cash flows and will discount cash flows back to the present. Utilizing the DCF requires forecasting future cash flows and concluding the necessary total return. After forecasting future cash flows (both incoming and outgoing) you then discount the projected cash flows back to the present-time at the necessary rate of return.