Saturday, May 12, 2012

How To Analyze The Cash-on-cash Return

The Cash-on-Cash Return is a measure of an income producing property's interest rate return on invested equity. The ratio is derived by taking the annual net cash flow (i.e., the cash flow available to the investors) divided by the equity invested.

Cash-on-Cash Return = Net Cash Flow / Invested Equity

There are four types of cash-on-cash return: Leveraged, Unleveraged, Before Tax and After Tax. Consider the following examples:

Example 1: Suppose an investor purchases a property for ,000,000 with an equity investment of 25% - ,500,000. At the end of the first year, the available cash to be distributed to the investor is 0,000. The leveraged, before tax cash-on-cash return would be:

0,000 / ,500,000 = 0.08% x 100 = 8.00%

Example 2: Let's assume the investor has a federal and state tax rate of 25%. Then, the leveraged, after tax cash-on-cash return would be:

0,000 x 25% = ,000
0,000 - ,000 = 0,000

0,000 / ,500,000 = 0.06% x 100 = 6.00%

Example 3: Alternatively, the investor purchased a property with all-cash for ,000,000. Since there are no loan obligations, the investor is entitled to all of the net cash flow available. Assuming the property has a net cash flow of 0,000 then the unleveraged, before tax cash-on-cash return would be:

0,000 / ,000,000 = 0.074% x 100 = 7.40%

Example 4: Again, let's assume the investor has a federal and state tax rate of 25%. Then, the unleveraged, after tax cash-on-cash return would be:

0,000 x 25% = 5,000
0,000 - 5,000 = 5,000

5,000 / ,000,000 = 0.0555% x 100 = 5.55%

Similar to a cap rate, the cash-on-cash return is a simple metric an investor can use to evaluate the potential return of a property (i.e. risk) versus an alternate investment such as a US Treasury Bond. It is a reliable tool for stabilized properties but does have several short comings an investor should consider.

Shortcoming #1: Cash-on-cash is most reliable in the first year than in the future years. This is due to the immediacy of the income. Most property buyers try hard to accurately reflect a property's first year of operations in their pro forma. However, the projections for the following years are all subject to the buyer's assumptions. Those assumptions can prove wildly incorrect.

Shortcoming #2: Cash-on-cash can be manipulated by the property's performance both good and bad. A property that is forecast to operate at 93% occupancy but is operating at 95% occupancy may produce a higher cash-on-cash return for the investor. Alternatively, the same property could be at 92% occupancy and the owner may choose to defer certain maintenance items to maintain his cash on cash. In this scenario, the cash-on-cash return may be what was projected but it comes at a future cost as deferred maintenance will need to be performed sometime.

Shortcoming #3: Returns are increased by interest only mortgages. Since a principal payment does not need to be made there is more cash flow available to the investor. This will provide higher cash payments but will reduce the sale proceeds at the end as a greater amount of principal will need to be prepaid

Shortcoming #4: It does not take into account property appreciation. Some investors may opt for lower cash-on-cash returns to invest in a property that has a greater chance of appreciation than purchasing a property with stabilized cash-on-cash returns but little to no appreciation.

Shortcoming #5: The less equity into the property, the higher the cash-on-cash returns. It stands to reason that the less equity used to purchase an asset the greater the returns to the investor. Some may argue this is not a shortcoming. However, consider that by putting less equity into a property up front it increases the risk to the investor when it comes time to refinance or sell especially if the property has had little appreciation or has experience depreciation. If you are tempted to do this make sure that the reward is well worth the risk.

It should be noted that most cash-on-cash returns are quoted before tax. The main reason is that each investor's tax situation is unique. An investor should use cash-on-cash return as just one of several metrics in evaluating a specific property for purchase.

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