In a previous post we discussed capitalization rates and why they were interesting but not the best measure for the residential investor. An alternative financial property valuation formula commonly used in real estate investing is the return on cash invested. Called the Cash on Cash return (CoC), and the case for its use is a strong one.
CoC is calculated by dividing the property's net operating income by the amount of cash initially invested. Pretty simple. We will cover that a little deeper later in this post. One other thing to remember about this formula. There is no way to know the ultimate return at liquidation. So, CoC gives an investor a current measure of return which can help make a buying or selling decision.
Many investors like to talk about capitalization rates. This is primarily because cap rates provide a comparison figure that actually allows you to establish an interest rate to compare to markets. This interest rate represents the percentage that borrowing costs should not exceed. So, for example, if the costs of borrowing exceed the given cap rate, essentially you have a negative return.
Confused? There is a much simpler way to measure returns and consider the cost of loans for the property . CoC is special because it accounts for the cost of borrowing and provides a return on the actual funds invested.
Remember, like most financial ratios, the CoC return is likely not the one absolute metric to use for your buying decision. It does not include other things like appreciation and tax benefits. Those items require different measurements.
Here is how CoC is calculated:
Cash Flow Before Tax (Annual net operating income of the property less annual debt service (principal + interest and costs of obtaining loan) divided by the Cash Invested (the down payment + cash spent on repairs or renovation).
The resulting ratio has many implications but a common one is to compare the ratio to other alternative investments where the cash invested could be deployed. If your rental is providing a cash on cash return of 4%, I suspect you may want to compare that investment to other choices.
Typically, if you are using debt, the debt service is taken out of the Net operating income. This deduction allows for an investor to better understand the actual returns with using debt and not using debt for an investment. Taking the debt service out may or may not have a negative effect on the cash on cash ratio. You need to look at all the other factors such as the interest rate, term of the loan, and the amount financed.
Many people use the CoC ratio to decide how much money to invest, how much to borrow and even whether to invest in a property at all. This is why you see many real estate investments with cash on cash returns stated. Be careful! Make sure you understand exactly the assumptions used in the stated return. Your costs (including financing) may be very different from the assumptions used.
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