The cash-on-cash return of an investment property is a measurement of its cash flow divided by the amount of capital you initially invested. This is usually calculated on the before tax cash flow, and is typically expressed as a percentage.
Cash-on-cash returns are most accurate when calculated on the first year's expected cash flow. It becomes less accurate and less useful when used on future years because this calculation does not take into account the time-value of money (the principle that your money today will be worth less in the future).
Therefore, the cash-on-cash return is not a powerful measurement, but it makes for an easy and popular “quick check” on a property to compare it against other investments. For example, a property might give you a 7% cash return in the first year versus a 2.5% return on a bank CD.
The cash-on-cash return is calculated by dividing the annual cash flow by your cash invested:
Annual Cash Flow / Cash Invested = Cash-on-Cash Return
Let's make sure we understand the two parts of this equation:
The first-year cash flow (or annual cash flow) is the amount of money we expect the property to generate during its first year of operation. Again, this is usually cash flow before tax.
The initial investment (or cash invested) is generally the down payment. However, some investors include their closing costs such as loan points, escrow and title fees, appraisal, and inspection costs. The sum of which is also referred to as the cost of acquisition.
Let's look at an example. Let's say that your property's annual cash flow (before tax) is $3,000. And let's say that you made a 20% down payment equal to $30,000 to purchase the property. In this example your cash-on-cash return would be 10%.
$3,000 / $30,000 = 10%
Although the cash-on-cash return is quick and easy to calculate, it's not the best way to measure the performance and quality of a real estate investment. Future articles will introduce you to better ways to evaluate your real estate investments.