Investing isn’t something people learn about in grade school. Most people stumble their way through financial markets until they teach themselves something that works, either by trial and error or through reading articles like this to get a head start.
Like any other industry, financial markets use some terms differently than they’re used in day-to-day life. Some terms are only used in the world of finance. One term that’s worth getting to know is “cash-on-cash return.”
What Is Cash-on-Cash Return?
Cash-on-cash return is a metric investors use to determine the amount of cash they stand to generate later from an outlay of cash now. The term is most commonly used among real estate investors and other investors that make income investments.
Think of it this way:
Before an investor buys a real estate property with six units for $750,000, they need to know things like:
- Average Rental Costs. How much money can the investor charge tenants and maintain the real estate’s status as a competitive housing provider?
- Average Fill Rate. Are all six units typically rented at all times? Or is the current owner only able to rent two units consistently?
Once the investor knows these details, they can calculate the cash-on-cash return to see if the investment is worthwhile or if their money is better used elsewhere. Investors typically look for a high cash-on-cash return rate.
How To Calculate Cash-on-Cash Return
How do you determine cash-on-cash return? The formula is as follows:
Cash-on-Cash Return Formula
cash-on-cash return = ANCF / IE
This is a relatively simple formula. Investors simply need to divide their expected annual net cash flow — on a pre-tax basis — by the invested equity, or initial investment, to generate the cash-on-cash return of an investment opportunity.
However, there may be some work involved in determining the annual net cash flow in investments like real estate. There’s no guarantee if an investor buys a rental property that they’ll be able to rent all units consistently or change what they expect to charge for rent. Rental occupancy rates and prices fluctuate.
With that in mind, it’s important that investors do their research and form a detailed understanding of the investments they’re making before they calculate cash-on-cash return. If they calculate this based solely on the maximum annual net cash flow potential, they may be painfully surprised after making the investment.
Taking the time to determine market trends and a reasonable expected monthly cash flow better prepares the investor when making their investment.
Cash-on-Cash Return Example
Say an investor is thinking about purchasing a six-unit piece of real estate for $750,000. They find that $1,800 is the average income for each unit of this specific piece of real estate and that they can expect to rent them out about 80% of the time. The investor should take the following steps to calculate cash-on-cash return:
- Multiply the number of units (6) by income per unit per month ($1,800) for a total of $10,800 per month.
- Multiply monthly cash flow ($10,800) by 12 to get annual cash flow for a total of $129,600.
- Divide the investment’s annual cash flow ($129,600) by the initial cash layout ($750,000) for a cash-on-cash return rate of 17.28%.
Why Is Cash-on-Cash Return Important?
Cash-on-cash return is a crucial metric for investors to calculate before making an income investment for two reasons.
Investment Opportunity Comparison
When investors buy real estate, they typically have plenty of options to choose from. One of the best ways to compare those options is to calculate cash-on-cash returns for each and then compare each investment’s likely returns to the others. Investors are more likely to invest in a building with a 20% cash-on-cash return than one with a 10% return.
Cash-on-cash return also tells investors how quickly they’ll get their initial outlay of cash back. For example, it takes 10 years for investors to recoup their investment dollars in an investment with a 10% cash-on-cash return.
The trick is to divide 100 by the cash-on-cash return. The result is the number of years it will take to recuperate the initial investment.
Cash-on-cash returns are simplistic in nature and shouldn’t be any investor’s singular basis for making an investment decision. Investors should do their due diligence and consider all data they can find before deciding to nest their hard-earned money in one asset or another.
FAQCash-on-cash return can be a complex topic and is often met with questions. Answers to some of the most common questions can be found below.
- What is a 20% cash-on-cash return?
- A 20% cash-on-cash return means investors earn 20% of their cash outlay from their investment each year. This also means it will take the investor five years to recuperate their investment dollars at current return rates.
- Is cash-on-cash return the same as ROI?
- ROI calculates the total return of an investment, including debt burden. Cash-on-cash return doesn't involve debt costs associated with investments.
- Is cash-on-cash return important?
- Cash-on-cash return is crucial for investors interested in making income investments. It tells them how long it will take to recuperate their cash outlay for income investments. It's also an effective way to compare investment options to determine which has the most potential to produce meaningful returns.
- What's the difference between cash-on-cash return and IRR?
- Cash-on-cash return and IRR, or internal rate of return, both show investors how much cash return they can expect from their investments. The difference between the two is that cash-on-cash return shows investors how much cash they'll generate in a typical year from their investment, while IRR shows investors how much cash they're likely to generate over the life of the investment, rather than in a single year.
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- Forbes Advisor. 2022. "Return On Investment (ROI)."
- PropertyMetrics. 2022. "Cash on Cash Return: A Beginner’s Guide."
- FortuneBuilders. "Cash On Cash Return & What It Means For Real Estate Investors."
- Forbes. 2022. "Understanding Real Estate Investment Returns."
- Reliant Management. "What is a Cash on Cash Return?"
- Federal Reserve Bank of St. Louis. "Rental Vacancy Rate in the United States."