If your understanding of investments are limited to a CAP rate in selecting an investment property in today’s market, you will want to understand what a Cash on Cash return is.
In the past, many investors would benchmark a property investment based on a CAP rate. The CAP rate represents the net operating income compared to the sales price. In other words, if the gross income is $150,000 and the expenses total $50,000, your net operating income (NOI) is $100,000. If you purchase the investment for $1,000,000, the CAP rate would be 10%, known as a “10 CAP”.
However, CAP rates takes into consideration only NOI and sales price. In times where financing has assumed more restrictions on equity (down payment) and higher interest rates, you will want to learn about alternative methods of analyzing investments. For instance, if your down payment or equity became 30% or 40% in order to actually finance this $1,000,000 building, the increased out of pocket cash is not taken into consideration in analyzing your investment. You still have a 10% CAP investment whether you have 20% down ($200,000) or 40% down ($400,000). In view of this, you must take into consideration how much money you are putting down in analyzing your investment especially when financing is more difficult to predict.
Cash on Cash analyzation is comparing the cash flow in the first year with the actual amount of equity you put down. Cash flow is the amount left over when you pay your loan obligations to the bank. There is cash flow before tax and cash flow after tax. Since the tax obligation is different for everyone, we are going to only talk about cash flow before tax. If you take all of your monthly payments that you owe to the bank for a whole year, this amount is your annual debt service. In order to come up with the cash flow amount, we need to take the net operating income (gross income minus expenses) and subtract the annual debt service to arrive at our cash flow for the first year.
For example, the building of $1,000,000 has a down payment of 20%, 6.5% interest, 20-year amortization, with payments of $5,964.59 per month. The annual debt service is $71,575. With the net operating income of $100,000 and the debt service of $71,575, your cash flow is $28,425. By comparing the first year cash flow with the amount of equity you paid out to get the loan going (down payment of $200,000), you have $28,425/$200,000 or 14.21% cash on cash return for the first year. You can think of this as a CD account or savings at a bank. If you put $200,000 in a savings account and get back $28,425 at the end of the year, your interest rate would be 14.21%. Keep in mind you still have a 10% CAP rate for this investment.
Now, let’s get realistic. The chance of getting this loan at 6.5% is not happening. Forget about a 20% down payment. The bank tells you that in order to get this loan, they will need 35% down and 7.5% interest. With 35% down ($350,000), your monthly payments are now reduced to $5,236.36 with annual debt service at $62,836.27. Cash flow will equal NOI ($100,000) minus debt service ($62,836) to arrive at $37,164. Cash on Cash percentage is $37,164/$350,000 or 10.62%. Keep in mind you still have a 10% CAP rate for this investment.
CAP Rate
NOI
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Sales Price
Cash on Cash
Cash flow first year
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Equity Down Payment
Cash on Cash is the only analyzation method that takes into account financing comparing cash flow with down payment. Cash flow is the amount remaining after debt service, which may include a higher interest rate. These variables are vital in considering an investment and financing alternatives in today’s market. Despite both investments having a 10% CAP rate, one had a 14.21% cash on cash return, while the other had a 10.62% cash on cash return.
Make sure your real estate investment professional understands these alternative analyzing methods.
Chad Razmus has been helping clients over 7 years with their real estate investments and has over 160 hours of training from the Certified Commercial Investment Member program for commercial real estate analysis. If you have an investment property that you are thinking of understanding better, please email me at crazmus@ccmichigan.com.
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