Typically, when investors start evaluating a new real estate deal, they may look at the internal rate of return and the equity multiple as guideposts to understand its potential performance, and determine whether the returns are commensurate with the risk of the investment.
However, for certain investments, it may make more sense to also review a different metric: the cash on cash return, which is the ratio between annual operational net cash flow and the total amount of cash (equity) invested in the deal.
In this piece, we will further explain how to calculate the cash on cash return, and the optimal investments to evaluate using it:
Cash on Cash Return Explained
The cash on cash return is used by sponsors when acquiring a property to understand the current and future income profitability on their initial invested capital.
The metric is calculated by this simple formula:
Cash Flow / Invested Cash = Cash on Cash Return
To determine the cash on cash return, first calculate the property’s invested cash, or the denominator in the equation, by summing up all capital contributed in the deal as equity. This will equal the total equity invested in a deal, including but not limited to equity used to acquire a property, any closing costs or fees paid with equity, and any renovation costs capitalized with equity contributions.
Next, find the property’s annual cash flow (the numerator), which is the difference between gross income, expenses, required reserves, capital expenditures, and debt service.
A property’s gross income is derived from its rents and other payments received, such as parking fees, pet fees, and utility reimbursements to name a few. Expenses generally include maintenance, administrative fees, marketing, insurance, and property taxes among others. The difference between the gross income and expenses is the property’s net operating income (NOI).
The sponsor will pay debt service for the mortgage and any other loans on the property with the NOI, and the residual is the cash flow, which can be used for capital projects to further enhance the value of the property, or it can be distributed to investors.
After determining both the initial invested cash and the annual cash flow, just insert those numbers in the aforementioned formula to find the cash on cash return, and express it as a percentage.
Here’s a hypothetical cash on cash return example for the acquisition of a $50 million multifamily investment property with 75% leverage: The initial equity invested to acquire the property along with financing was $12.5 million. Additional equity funded at closing included $5.5 million for renovations and $2 million for closing costs not covered by the loan. Altogether, $20 million in initial cash was invested. After operational expenses, the property has $4.1 million in NOI over the course of one year and debt service for a non-amortizing loan was $2.1 million, leaving annual cash flow of $2 million. In this hypothetical scenario, the cash on cash return would be 10% as indicated below.
$2MM (Cash Flow) / $20MM (Invested Cash) = 10% (Cash on Cash Return)
When is the Cash on Cash Return Relevant?
Now that we’ve explained the cash on cash return and how to calculate it, it’s time to talk about the optimal time to use it.
While no two real estate deals are exactly the same, there are categories of real estate investments that have similar business plans. Some are short-term, ground-up deals, meaning the property is expected to be developed, stabilized (or fully leased), and sold within a few years. Others could be value-add deals that target producing steady income over a long period of time.
For the prior, the emphasis is on creating a new asset that’s highly valued and realizing upside on a sale rather than distributing cash to investors regularly. The later are typically older vintage properties that tend to appreciate in value slowly, so the hold period is longer, but there may be steady income payments distributed to investors along the way.
Since the cash on cash return is a measurement of how much potential annual cash flow a real estate investment can produce, it’s a good tool for investors who are comparing an equity real estate investment to other steady income producing vehicles, such as bonds or preferred equity investments.
It’s important to remember though that no one tool can be relied upon solely when evaluating an investment, and that applies to the cash on cash return as well. Since this metric is a snapshot in time, meaning it is calculated prior to the investment being made by utilizing the project’s potential performance, it does not take into consideration the impact time could have on investors’ capital (often referred to as the time value of money). Investors should use the cash on cash return in conjunction with other return metrics, such as IRR, when evaluating investment opportunities.
ArborCrowd looks at more than 500 deals each year but only selects the few that survive our rigorous underwriting process. Some of those deals have longer-term business plans that are projected to produce steady cash flow, and are suitable for a cash on cash return analysis.
Regardless of the targeted returns a sponsor may present for a property, what allows a deal to be selected for ArborCrowd’s platform isn’t solely its potential for rapid appreciation or steady cash flow, but whether it has strong real estate fundamentals, a solid business plan that aligns with market demand, and experienced sponsorship.