Cash-On-Cash ROI? Calculate It.
Cash-on-cash ROI (return on investment) is a Calculation that tells you the return you made on the cash portion of what you put into your investment.
It doesn’t take into account the money that you borrowed and used, just the amount of your own cash that you put in.
It is an excellent way of looking at how well you are managing your cash, and how much you are getting back by investing it.
Unfortunately, it is usually calculated incorrectly.
I’m sure there is an accurate explanation somewhere of how to do it, but it is not on the Blogs and Podcasts that I follow, all of which seem to re-publish content that they take from each other.
Nor is it on the “bigger” real estate investing forums where well-meaning members come and repeat the same incorrect information.
So let’s come back to ground zero on “Cash-On-Cash Return,” and take off again.
Today, we’ll talk about the best way to use the cash-on-cash ROI (return on investment) Calculation.
We’ll look at what should go into the Calculation, what should not go into it, and how you can change the way you do the Calculation to learn what you need to know for your particular situation so that you can make the best decisions.
Investors use all sorts of Calculations, to recast their business operations as numbers so that they can track, compare, analyze, and sometimes experiment, to manage most effectively.
Everyone is primarily concerned with the Calculation called Return On Investment (ROI). This calculates how much net income you are receiving on the total cost of your entire investment.
But many investors believe that Investment ROI is not as important as the return that they receive on the actual cash that is invested in a project, because cash is what you have of your own personal assets that you put into the investment.
It is probably also your “limited resource,” at least in the beginning of your investing career. And therefore, it requires the most attention.
Every investment requires certain elements to be combined to create the investment. And every beginning investor is usually limited in at least one of these elements, or “resources,” and therefore must focus more on this “limiting resource” in order to compete.
The rest of the money put into the investment, is acquired somewhere else, through a loan, and you have many options about where to get it.
The borrowed money is just another element, or expense, of the buying and rehabbing project, like counter tops or landscaping.
Debt is only one of the items making up the total investment property.
But actual cash is limited, and critical, because you only have so much.
And you need to measure the return on your investment, based on what you personally put into the investment.
That’s Cash-On-Cash ROI.
CASH-ON-CASH ROI CALCULATION
So, the Cash-On-Cash Return (COCR) is the relationship between a property’s income and the initial cash invested.
But, there is another, more relevant, and more useful way to look at the Calculation.
“Income” is a number that you calculate, and it is affected by deductions from income in the calculation such as depreciation, which is not really a cash expense, and so “income” is not really “cash,” the same as the “cash” that you invested.
So the Calculation really involves “apples and oranges.”
But if we replace “income” with “cash flow,” we are talking about the same thing, and we can make an accurate comparison, between Cash Flow (CF) and the Initial Capital Investment (ICI), because they are both cash, as in actual dollars.
In other words, Cash-Out compared to Cash-In.
And we have a Calculation for that.
The Cash-On-Cash Return equals the Cash Flow divided by the Initial Capital Investment.
For example, if it took you $50,000 to get into the property, and it cash flowed you $10,000 the first year, your Cash-On-Cash Return is 20%.
Let’s look at the Calculation.
COCR = CF divided by ICI, where
COCR is the Cash-On-Cash Return,
CF is the property’s Cash Flow, and
ICI is the Initial Capital Investment required to get into the property.
UNDERSTANDING THE ROI CALCULATION
First, let’s establish that “Initial Capital Investment (ICI)” is the initial cash Down Payment that you made, plus all of the costs of acquiring the property, usually the Closing Costs that are detailed on your HUD-1 Settlement Statement, which you also paid at Closing.
Now, there can be some confusion about exactly what makes up your Initial Cash Investment, but there shouldn’t be.
I just listened to a certain popular Podcast where the very young host said that your ICI is also the rents that you lost for the first three months while you were trying to rent the property, plus some other nonsense. This is just someone who has no experience as a Real Estate Investor making stuff up.
Be careful not to wander off into the tall weeds with this Calculation. Try to understand it, and just put in what it asks for, and you will get a useful number.
Now, let’s look at Cash Flow. We need to determine how we will define Cash Flow (CF) because CF seems to have a different definition, depending on the circumstances in which it is being used.
Cash Flow is actually the cash left over after you take the monthly cash income from the property, and pay all of the monthly cash expenses of the property.
In other words, it is cash in, less cash out.
It even has its own Calculation.
Cash Flow equals Income minus Expenses.
CF = I – E, where
CF is Cash Flow,
I is all of the cash Income, and
E is all of the cash Expenses.
The Cash Flow Calculation is normally used to create a profile of a property so that you can compare it to another property.
Therefore, Cash Flow should only include those characteristics of a property that all other properties also have. Otherwise, you cannot compare them.
What the properties have in common.
So, the Income of the property should only include the cash produced by the operation of that property.
Some Cash Flow Calculations include as “Income,” proceeds from a loan secured by the property.
And some Cash Flow Calculations include as “Income,” interest on funds held by the owner of the property that came from the past operation of the property.
I mention this so that you will know. These two items should not be included in Income. They do not measure the character or the operation of the property.
And on the Expense side of the Calculation, some Cash Flow Calculations include Debt Service (DS) as one of the Expenses that are deducted from the Cash Income. DS is usually the entire note payment on the loan used to purchase the property.
This is not the correct way to do it, and I’ll explain why.
One of the reasons that you want to calculate CF in the first place is so that you will know how much cash you will have monthly from this investment to use to retire the debt. That means to make the principal portion of the Note payments. The principal portion of the Note payment is not a cash operating expense of the property.
But the interest portion of the Note payment is an operating expense. It is the cost that you are incurring for the use of the funds that you borrowed.
So, deduct the interest portion of the Note payment, but not the principal portion.
So, let’s go back to Cash On Cash Return (COCR), and look at an Example.
Let’s say you can buy a Fourplex for $400,000 and you can get a 75% loan, meaning that your cash down payment will be $100,000.
Your closing costs will be $10,000 and you anticipate spending another $15,000 to increase the income capability of the property to its highest possible level.
$100,000 plus $10,000 plus $15,000. Your total cash investment will be $125,000.
You Calculate your Cash Flow to be $23,040 so you can Calculate your COCR at this point.
COCR = CF ÷ ICI
COCR = 23,040 ÷ 125,000
COCR = 0.18432 = 18.43%
This is the most accurate way to use the Calculation, but if you want to deduct all of your Note payment and see what your COCR is, what you have left to put in your pocket to return to you what you took out of your pocket, we can do that as well.
Your Debt Service is $1,500 per month, $18,000 per year. But most of this $18,000 that you paid was for interest, which you have already deducted as an expense. Only $3,000 was for reduction of principal.
This would leave you a Cash Flow of $20,040.
COCR = CF ÷ ICI
COCR = 20,040 ÷ 125,000
COCR = 0.16032 = 16.03%
Of course, we can extend the analysis and note that the $3,000 that was used to pay down the Principal on the loan just increased your Equity in the property by that amount, which you will receive when you sell it, so that $3,000 is the same as money in your pocket instead of an expense of operating the business.
So, we really could add it back to the $20,040 Cash Flow.
Your Cash On Cash Return is a good tool for comparing two properties, but is best used for the initial decision-making process.
It is probably not as good for when you are making a decision to buy and hold a property for ten years, because of the changes that will occur over that period of time, and other changes.
The COCR Calculation does not take into account the annual increase in Cash Flow as you raise the rents, or the time value of money, both of which will change your Calculation.
But it is good for giving you an initial clear picture of what you are using your cash for, and the benefit you are receiving from it.
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