How Cash on Cash Return Can be an Investor's Best Guide Against Uncertainty
An urban renewal project
Real estate investment is a high risk, high reward equation where scams are common and affect unsuspecting, amateur buyers quite regularly. To avoid fraudulent schemes, investors need an unassailable approach.
They should know where they stand with their investment. In order to have awareness of their contribution, they must do their own calculations as well and not depend on others. A reliable way is using the method of cash on cash return.
Cash on cash return is employed primarily as an indicator of real estate investments and deduces the cash reaped if cash is deposited in a property. Realty is the only field where cash on cash return is used. Other areas use the return on investment formula.
The fundamental theoretical concept shows investors the cash they are bound to receive when they finance a deal as a percentage of the total amount invested as part of the transaction. We can use numbers to comprehend cash on cash. If an investor puts a down payment of 25%, then his return will be calculated on a yearly basis based on the 25% he invested in the beginning.
We have to consider the formula for cash on cash return to understand how it works. The calculation is made using pre-tax numbers. For the sake of elucidating the concept, we can use random numbers.
If an investment opportunity arises, it will have potential suitors. An investor will make a sizeable donation to corroborate his interest in the real estate. The condition of the investment is that monthly returns are not included. Let’s assume the value of the property is a million dollars and a down payment of 10% is made i.e. 100,000 dollars and the remaining amount is borrowed by the investor.
Besides the price of the property, acquiring it will also bring additional costs like maintenance and insurance expenses. Furthermore, the buyer would be liable to pay other costs as well. We can assume that they paid $25,000 in loan fees, comprising of $5,000 principal repayment, and the remaining $20,000 interest payments.
For any number of reasons, the investor may want to sell his property at this point. Let’s assume his value is estimated at 1.1 million dollars currently. We can use all the aforementioned numbers and determine his cash on cash return. His entire cash influx was $135,000, which consists of $100,000 paid to obtain the property, $10,000 sundry expenses, and finally, $25,000 loan payments.
On the other end of the spectrum, we will have $900,000 which is the borrowed amount less $5,000 which was paid earlier. This gives us $135,000 less $895,000 which would mean the remainder in the hands of the investor is $205,000. The cash on cash return will be decided by $205,000 less $135,000 divided by $135,000, which will be nearly 52%. That will be their cash on cash return. Therefore, the cash on cash return formula is net operating income divided by total cash investment.
Loans are often involved when a large investment is being made. We will examine two instances, one with and one without a loan. First of all, assume that the buyer does not obtain a loan. He will make a payment of 250,000 dollars to acquire the property.
Consider miscellaneous expenses as 3% of the total cost, which is tantamount to 7,500 dollars. This means his total cash input would be $257,500. We can attach a value of $2,000 per month to rent. That is $24,000 per annum. Operating expenses would be $8,000 which will be deducted from the rent earned, thus leaving us with $16,000. The formula will be applied and $16000 will be divided by $257000 which are equal to 6.2% cash on cash return.
Next, we can consider the calculations if the buyer takes a loan. To simplify this intricate method, we will use the same numbers we crunched above. Therefore, if they put 25% in down payment, then that is $62,500 and the sundry expenses are $7,500 which when added will give $70,000 in total. The debt service can be deduced by using 5% interest loan yield of $180,000. That is $9,000 dollars. Finally, $7,000 divided by $70,000 will give us exactly 10% cash on cash return.
The concept of cash on cash return is imperative in the world of real estate for a number of reasons. First and foremost, it is a simplistic measure, especially when you consider other methods which are used as well.
It is absolutely essential to know where you stand when you're making a significant investment. Cash on cash allows users to ascertain if they are making a sound investment. Beyond inferring the expected return, the formula is also helpful when it comes to predicting potential cash distributions. Buyers or investors can decide what targets they can meet and what goals they can accomplish. This aids their long-term planning.
There are varied opinions when it comes to the final result. What the ideal cash on cash return depends on who you ask. Some experts state that a return of 8% for example, would represent a good measure of success for the investment made. There are those that believe nothing less than a 20% return is a sound investment and that anything less is a waste.
However, there is a caveat to consider when deciding what the optimal cash on cash return is. It depends on the type of property. If money is invested in a residential estate, the return will differ from that of a commercial property. Moreover, while some buyers may adopt a higher risk factor since they can afford it, others may exercise caution and expect a low return on their investment. The general principle is that the higher investment you make, the greater the risk you're taking.
Also known as equity dividend rate, cash on cash return is an effective but simple metric used to glean the earnings you can expect when you are investing in property. The formula gives investors an idea of their transaction. The best possible approach is to set a high bar and this calculation can give buyers a considerable advantage.
Posted On June 21, 2018