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In This Article
- What is Cash on Cash Return, & Why is it Important?
- Cash on Cash Return Formula
- What is a Good Cash on Cash Return for a Rental Property?
- Benefits of Cash on Cash Returns
- Drawbacks of Cash on Cash Returns
- Cash on Cash Return Examples
- How Cash on Cash Returns Compare to Other Metrics
- How to Improve Your Cash on Cash Returns: 3 Ways
- The Bottom Line: Cash on Cash Return & Equity Dividend Rate
When considering whether or not to buy a real estate investment, one of the main deciding factors real estate investors use is profitability.
“Is this property going to make money short and long term?”
One formula that is critical to an investor’s success is cash on cash return, also known as the equity dividend rate.
In this article, we’ll explore what cash on cash return and equity dividend rate is and how you can use it to ensure that your next real estate deal will be profitable.
What is Cash on Cash Return, & Why is it Important?
Cash on cash return, or equity dividend rate, helps take the guessing work out of real estate investing.
Cash on cash return measures the income you could earn as a percentage of the cash you will invest in a property over a set period of time (generally one year).
It allows investors to analyze an investment’s cash flow without accounting for debt and, therefore, to determine the profitability of a property.
It’s also an excellent tool to utilize when comparing different rental properties in the buying process to determine which property will be more profitable.
Cash on Cash Return Formula
The cash on cash return formula divides the annual pre-tax cash flow of a property by the initial cash investment.
The cash on cash return formula is:
Cash on cash return = (Annual cash flow / Total cash invested)
Next, we’ll take a deeper look at each item in the formula.
Annual Cash Flow
To calculate the annual pre-tax cash flow, add the property’s gross rent to any additional earning opportunities, like parking fees. Then, subtract operating expenses, such as:
- trash collection
- HOA and bank fees
- property management
Total Cash Invested
The total cash invested generally includes:
- your down payment for the property
- your closing costs
- any pre-rental repairs and upgrades needed to make the property operational
- loan costs, though not including loan interest or payments
What is a Good Cash on Cash Return for a Rental Property?
Generally, a higher rate represents a higher cash on cash return and, therefore, a more profitable property.
However, what constitutes a good cash on cash return, or a good equity dividend rate, varies depending on the market and the investor’s goals.
As a rule of thumb, experts consider a property with a cash on cash return between 8% and 12% to be a worthwhile investment — and a cash on cash return in the double digits, such as 20%, is highly sought after.
Benefits of Cash on Cash Returns
Calculating the cash on cash return gives a more accurate picture of what you can earn from a property while putting in the money required to be operational.
By using the cash on cash return formula instead of other popular forms of calculation, you as an investor can also get a more accurate forecast of when the property can become profitable and when to schedule expenses.
Plus, if you’re looking at multiple properties, you can get a better idea of which property will be more profitable, helping you in your decision making.
Drawbacks of Cash on Cash Returns
Although cash on cash return is an essential tool for real estate investors, it has its shortcomings, and it shouldn’t be the only formula you should use when judging the profitability of a property.
The cash on cash return loses its value over time as the amount of money invested — by paying down the loan and maintaining the property — increases.
Generally, it is most accurate in the first year of owning the property and should be calculated every year to account for any changes.
Since the first year of owning a rental property often has the most expenses, determining the cash on cash return can skew the numbers, given there will not be nearly as many expenses in later years.
Keep in mind that the cash on cash return does not account for several factors. Since the cash on cash return formula is calculated pre-taxes, it does not include the investor’s tax bracket and tax outflows, including the tax benefits.
The cash on cash return does not take the return on capital or risk factors into account, either.
Cash on Cash Return Examples
The cash on cash return formula is simple to use and allows investors to quickly assess their properties’ cash on cash return.
Here are some examples of how the cash on cash return formula works.
An investor bought a rental property for $150,000 and paid cash.
He rents it out for $2,500 a month but spends $500 a month on maintenance.
Therefore, his annual pre-tax cash flow is $24,000: ($2,500 - $500) x 12 months.
To determine his cash on cash return, we divide the $150,000 in cash that he invested by his annual cash flow ($24,000).
So in this example, the cash on cash return is 16% ($24,000/ $150,000).
Let’s consider that the investor took out a mortgage to buy this same property instead of paying cash for it, and he paid 20% down, or $30,000.
The monthly income remains $2,500, and the monthly maintenance remains $500, but now the investor has to pay $1,000 each month for the mortgage.
In this scenario, his annual pre-tax cash flow is $12,000: ($2,500 - $500 - $1,000) x 12 months.
Using the cash on cash return formula, we see his cash on cash return reduced to 8%.
How Cash on Cash Returns Compare to Other Metrics
Next, we'll look at how cash on cash returns compares to other metrics, such as cap rate and ROI.
Cash on cash vs. Cap Rate
The cash on cash return formula calculates the potential profit investors earn for every dollar they spend.
It compares their annual return to their total investment.
The profit percentage can differ among investors for the same property because their variables, like rental income and financing terms, are different.
Therefore, the cash on cash return is different.
A capitalization rate, or cap rate, is used to evaluate comparable properties located in the same market and measures the potential value of a property.
In short, it compares the annual return to a property’s market value.
While the cash on cash return formula calculates the return for the investor, the cap rate formula calculates the return on the property itself.
Unlike the cash on cash return, the cap rate can be the same percentage among investors in the same market.
The formula for cap rate is Net Operating Income / Market Value.
While cap rate does consider operating expenses, it does not include mortgages.
Cash on Cash vs. ROI
Return on Investment (ROI) is another formula that is frequently used to compare real estate investments that some investors use interchangeably with cash on cash return, though the two have differences.
The cash on cash return formula only considers returns relative to any money spent out of pocket by the investor.
Meanwhile, the ROI measures all returns for the property, including its debt, or loans.
Another key difference between cash on cash return and ROI is the period of time.
It is common to see cash on cash returns calculated in annual cycles — ROI covers the time you hold the property.
The formula for calculating ROI is: (gain from the investment - cost of the investment) / cost of the investment * 100%.
How to Improve Your Cash on Cash Returns: 3 Ways
Investors can improve their cash on cash return in several ways.
Here are the quickest and most effective ways:
#1: Increase your Property’s Value
Making improvements to your property is the quickest way to increase your cash on cash return.
Homes that are updated are more appealing and collect higher rent payments.
#2: Increase the Rent
If you haven’t raised the price for monthly rent in a while, doing so will help increase your cash on cash return.
As mentioned above, you should certainly consider raising the rent if you’ve made improvements since the last rental fee increase.
#3: Lower the Operating Costs
Operating costs affect the cash on cash return and are one of the variables in the cash on cash return formula.
It costs landlords money to own rental properties.
These charges could be maintenance, mortgage fees, or having an empty rental because the tenant moved.
An empty rental property is expensive because operating costs continue despite not having an income from the vacant property.
Vacancies harm the cash on cash return quicker than anything else.
Long-term tenants provide a level of security to landlords and are one of the best ways to lower your operating cost and increase your cash on cash return.
The Bottom Line: Cash on Cash Return & Equity Dividend Rate
Though cash on cash return, or equity dividend rate, is a valuable tool in the toolbox for real estate investors, it’s not a one size fits all answer to the questions you may have about a property — or about real estate investing itself.
Keep in mind there are other tools, and other formulas, that need to be factored in, such as after repair value (ARV).
The difference between a profitable deal and a deal that loses money is education, which is why it's critical to utilize additional resources to further your real estate education.