There is a metric in apartment investing known as cash-on-cash return. It represents the power of multiplying money. Consistent investment in strong performing assets over long periods of time yields the greatest return, so knowing how to calculate that return is essential.
For many, it’s not the acquiring of money that’s the issue. According to U.S. Census data I analyzed, more than one 1 in 4 households in America earns over $100,000. Knowing how to deploy that capital to work for you is the real problem. Here’s how to invest so that your cash is constantly producing cash whether you’re working, sleeping or even on vacation. As James W. Frick brilliantly stated, “Don’t tell me where your priorities are. Show me where you spend your money and I’ll tell you what they are.”
What is a cash-on-cash return?
Cash-on-cash (CoC) is a metric that determines how much cash is returned as a ratio of the cash invested. This is not to be confused with the overall rate of return. For every dollar you invest in an apartment complex, you should know what percentage of return it will earn you. This is a very important metric and gives you a snapshot of how a property should perform.
While some investors may pay cash outright for a property, money is truly leveraged and the most powerful return is achieved when the property is financed at a lower percentage than the overall return. After subtracting out all the expenses, repairs, principal/interest, utilities, payroll, marketing, etc., the remaining cash before taxes is the focus. This amount of annual cash divided by the total amount of cash invested is known as CoC.
How To Calculate Cash-On-Cash
Cash-on-cash return = (annual before-tax cash flow) / (total cash invested)
The annual before-tax cash flow represents the total cash after all expenses but before taxes, as the name suggests. The only small side note here is that the appreciation or depreciation of a property is not considered an expense, and therefore not normally calculated into CoC.
Assume we bought a $1 million apartment with a $250,000 down payment. Every month we must pay the mortgage (principal and interest) as well as any expenses such as electricity, water, trash, cable, turnover, payroll, marketing, repairs, management fees, lawn care and any other expenses. First, we take the total yearly rental income ($300,000), subtract the mortgage payment for principal and interest ($125,000) and subtract all expenses ($150,000).
Annual rental income ($300,000) – mortgage ($125,000) – expenses ($150,000) = annual before-tax cash flow ($25,000)
Then, we divide this by the total cash invested (not yearly, but the overall total), which was our down payment of $250,000.
Annual before-tax cash flow ($25,000) / total cash invested ($250,000) = cash-on-cash return (10%)
In this scenario, the property would produce a 10% cash-on-cash return. In many markets this would be an incredible return, but in some scenarios, like owning a trailer park, 10% CoC would be low. Understanding the importance of this metric and knowing how to compare it in different deals is the next step.
Importance And Comparison Of Cash-On-Cash Return Formula
Typically, the CoC is lower in areas that are more desirable. The CoC in Beverley Hills will be much lower than the CoC in a small west Texas town. An investment in Beverley Hills is justified more by the appreciation of the property over long periods of time, not necessarily the monthly cash flow.
Are you an investor looking for a higher monthly cash flow (with possibly lower appreciation) or are you looking for a higher appreciation (with possibly a lower cash flow)? This leads us to our next comparison.
Let’s assume we have two properties, but they’re not apples to apples. One is a beautiful, brand-new apartment complex with all the most modern amenities; the other is a run-down mobile home park. Even though these can be very close in proximity, the CoC will greatly vary between the two because of the type of asset.
If a trailer park returned CoC at 10%, most wouldn’t even consider looking at it; but a brand-new Class A apartment that returned a 10% COC would have a long line of investors wrapping around the block. Basically, you can get a large portion of return upfront (high CoC, low appreciation) or a large portion of return down the road (low CoC, high appreciation). Neither of the two is inherently better than the other, but you must know what you are looking for in your investment, how to calculate the risk and the corresponding reward.
Finding The Best Deals
For most investors in the early part of their career, high CoC is important since cash flow is the lifeblood of the industry and the focus is wealth creation. Toward the later years as a very successful investor, one may be focused more on wealth preservation, and therefore a lower CoC with high appreciation may be more important.
Know the criteria that creates the ideal investment for you, and then begin to research. Consider the geographical location, the year of construction, proximity to a metropolis, asset class, school system, crime rates, average household value and average household income. These are just a few scales that can help narrow and find a suitable property to perform as expected. Research to become familiar with the surrounding area and, most importantly, take action. The biggest mistake anyone can make in this business is to not start.
While the numbers provide insight into how a property should perform in the future, know that these are rules of thumb. Trust your instincts, but always take action when you find the right deal. Put your money to work for you. Invest it in the right property in the right location at the right time. Don’t let your money (or lack thereof) control your life; make sure you are controlling your money. Like P.T. Barnum once said, “Money is … a very excellent servant, but a terrible master.”