What Is Cash On Cash Return (COCR)?
Cash on Cash Return is a metric used to measure the total return earned on the real investment property. The return is the total cash income earned on the investment property to put in simple words, Cash on cash return is earned by the investor made on by investing in the property than by mortgaging it.
It is calculated as the ratio of the total amount of rental income generated from the property and the total cash investment initially made in the property. Thus, it is a valuable metric that can be used to assess the profit-earning capacity of real estate. It helps investors compare properties for investment but does not account for tax benefits, capital appreciation, etc, which affect profitability.
Table of contents
- Cash-on-cash return determines the total return on the actual investment property. In addition, the return is the total cash income gained on the investment property.
- It is evaluated as the total rental income ratio created from the property and the primary cash investment. Using this, investors may compare the cash-on-cash returns in the real estate asset class and across classes.
- It is based on simple interest, not compound interest calculation. Therefore, an investment opportunity with a low compound interest rate is more favorable than an investment with a high cash-to-cash return.
Cash On Cash Return Explained
Cash on cash return is a financial metric that helps in evaluating the return on a real estate investment. It measures the income earned on the property with respect to the cash investment on the property.
The equity dividend rate gives the ratio of before-tax cash inflow by the amount of equity initially invested. It does not include the loans taken from the financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. while calculating cash on cash return ratio.
Although this is a simple metric, it does not tell everything about the rental property and should not be taken as the only measure to make an investment decision. COCR in real estate investing requires a deep and sophisticated level of analysis, which includes qualitative analysis like the property’s location, prospects of the area, commercial aesthetics of the location, among other factors.
A good cash on cash return ratio does not consider the tax benefits, alternative financing sources, or possible financing structure. However, a good COCR ratio remains the most basic and essential metric to indicate a better investment opportunity.
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The cash on cash return equation can be expressed in the following manner.
This formula shows that the equity dividend rate only measures the return on actual cash invested, i.e., the equity involved in the investment. Thus, the measure does not include the debt involved in purchasing the property, which is a common financing instrument in real estate.
How To Calculate?
As per the above mentioned formula, in order to calculate the real estate cash on cash return we need to divide the before tax cash flow generated from the real estate by the total amount of cash that is invested in the property. Thus, if a property can generate before tax cash flow of $15,000, an the cash that is invested in the property is $100,000, then the return will be 15%.
It proved the investor with a clear picture of the viability of the investment after considering the actual amount of cash invested in it. It facilitates comparison of different opportunities and and decide about where to allocate the funds.
Let us consider the example to calculate the real estate cash on cash return:
An investor purchases a property for $ 2,000,000 and receives a monthly rent of $ 8,000. He has to pay maintenance charges of the property of $ 2,000.
- Now, the monthly income on the property = 8000 – 2000 = $ 6,000
- Annual Income = 12 X 6000 = $ 72000
- Thus, COCR Formula = Annual before tax cash flow/Total cash Invested = 72000/2000000 = 3.6%
An investor purchases a rental property of $ 2,000,000 with a down paymentDown PaymentDown payment is the initial deposit made by the buyer to the seller when purchasing an expensive item, such as residential property or a car. It comprises a portion of the total purchase amount of the asset and takes place via cash, bank check, credit card, or online banking. of $ 500,000. He receives monthly rent of $ 8,000 and pays maintenance and interest charges of $ 4,000 every month.
- Now, the monthly income after expenses of the investor = 8000 – 4000 = $ 4,000
- Annual income = 12 X 4000 = $ 48000
- Thus, Cash on Cash Return = 48000/500000 = 9.6%
In the examples above, the loan increased this ratio. Loans or leverage increases the risk for the investor. Any damage, extra costs, impairment losses, loss of capitalLosses, Loss Of CapitalCapital Loss is a loss when the value of the consideration received from the result of the transfer of capital assets is less than the aggregate value of the cost of acquisition & cost of the improvement. In simpler words, it can be stated as the loss derived from the transfer of capital assets. have to be borne by the investor himself, and the banks need to pay back on time.
However, it is not always the case; this ratio depends on many other factors like the price, the loan amount, monthly rent, monthly loan payout, etc.
- The ratio is easy to calculate COCR. The ratio is easy and quick to compare returns from various investment opportunities. The ratio allows an investor to compare returns within the annual cash on cash return in the real estate asset class and across asset classesAsset ClassesAssets are classified into various classes based on their type, purpose, or the basis of return or markets. Fixed assets, equity (equity investments, equity-linked savings schemes), real estate, commodities (gold, silver, bronze), cash and cash equivalents, derivatives (equity, bonds, debt), and alternative investments such as hedge funds and bitcoins are examples..
- The annual cash on cash return calculation is based on before-tax cash flow to the total cash invested. Since the ratio’s numerator is before tax cash flow, it does not consider the individual’s tax bracket and tax outflows. The investment opportunity may be influenced by the tax benefitsTax BenefitsTax benefits refer to the credit that a business receives on its tax liability for complying with a norm proposed by the government. The advantage is either credited back to the company after paying its regular taxation amount or deducted when paying the tax liability in the first place. and the tax outgo of an individual, which are not captured in the return ratio.
- The cash on cash return does not account for the return on capital. A return on capital can indicate a higher return as the return on capital is not an income.
- Other risks of owning the property are captured in the ratio. An investor should do due diligence and the return ratio calculation before investing in the property.
- The ratio is based on simple interest to calculate cash on cash return and not on compound interest calculation. An investment opportunity with an even low compound interestCompound InterestCompound interest is the interest charged on the sum of the principal amount and the total interest amassed on it so far. It plays a crucial role in generating higher rewards from an investment. rate may be more excellent than an investment with a high cash-to-cash return.
- The ratio does not account for the time value of moneyAccount For The Time Value Of MoneyThe Time Value of Money (TVM) principle states that money received in the present is of higher worth than money received in the future because money received now can be invested and used to generate cash flows to the enterprise in the future in the form of interest or from future investment appreciation and reinvestment.. Hence, it gets effective only for the first year of investment if an absolute ratio is measured and the equity dividend rate on the single investment is measured.
Cash On Cash Return Vs Return on Investment (ROI)
Differences between COCR and Return on Investment (ROI):
Return on investment involves the total return on investment. It would consider capital gains on the investment as well. At the same time, this accounts for only the annual cash inflows. Since the COCR in real estate investing, the assets are held for a very long term, usually 10-20 years, capital gains are difficult to estimate. Further, capital gains on the property depend on the property’s location, geopolitical scenario, economic conditions, and other factors.
Thus, to measure and compare the investment in real estate investing, cash on cash return equation is a better measure.
What Is A Good Cash On Cash Return Ratio?
The absolute number for a good cash on cash return varies. Experts say an 8% return is a good ratio, whereas some experts look for a range between 8-12%. Some investors may not invest if they are not guaranteed 15% or 20% COCR.
Frequently Asked Questions (FAQs)
ROI determines an investment’s total return and includes the debt burden. In comparison, cash-on-cash recovery estimates the return on the actual cash invested and enables an appropriate analysis of the investment’s performance.
No. Cash-on-cash return does not comprise debt concerning the property. Only the down payment and closing costs are considered toward the initial investment in a mortgage.
These returns can be increased in several ways, including increasing the rental income, reducing operating expenses, improving occupancy rates, refinancing the property, and selling the property.
No, it does not include appreciation. Instead, it measures the cash income generated by the investment relative to the amount invested and does not consider changes in the property value over time.
This article has been a guide to what is Cash On Cash Return. We explain its formula, how to calculate, what is a good ratio along with examples. You can learn more about financial analysis from the following articles –