What is Cash on Cash Return (COCR)?
Cash on Cash Return is a type of metric that is used in measuring the total return earned on 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 and is calculated as the ratio of the total amount of rental income generated from property and total cash investment initially made in the property.
Formula
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For eg:
Source: Cash on Cash Return (wallstreetmojo.com)
This formula is to be noted 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 the purchase of the property, which is a common financing instrument in real estate.
How to Calculate Cash on Cash Return (with Example)
Let us consider the example by using the above COCR formula:
Investment Without Loan
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%
Investment in the Property with Loan
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. read more 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.read more have to born by the investor himself, and the banks need to pay back on time.
However, it is not always the case; this ratio depends on a lot of other factors like the price, the loan amount, monthly rent, monthly loan payouts, etc.
Cash on Cash Return and Return on Investment (ROI) Differences
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. Whereas 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 depending on the location of the property, geopolitical scenario, economic conditions, and other factors.
Thus, to measure and compare the investment in real estate investing, COCR is a better measure.
Advantages
- The ratio is easy to calculate COCR. The ratio is an easy and quick method to compare returns from various investment opportunities. The ratio provides an investor with an opportunity to not only compare returns within the cash on cash return in real estate asset class but 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.read more as well.
Disadvantages
- The calculation of COCR is based on before-tax cash flow to the total cash invested. Since the numerator of the ratio 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.read more 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, along with 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 small rate of 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.read more may be a superior opportunity than an investment with 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.read more. 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.
What is a Good Cash on Cash Return Ratio?
The absolute number for a good COCR varies. While the experts say that 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.
Conclusion
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. read more 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 location of the property, future prospects of the area, commercial aesthetics of the location, among other factors.
A good COCR ratio does not consider the tax benefits, alternative financing sources, possible financing structure. However, a good COCR ratio remains the most basic and important metric to indicate a better investment opportunity.
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