Real Estate Cash on Cash Return 

So what is a real estate investor's cash on cash return anyway? A real estate investor's cash on cash return can be described as your year 1 net cash flow, divided by initial cash invested in a real estate property.  Seems simple right? On the one hand, it is fairly simple but there are some things you'll need to know to be sure you're doing this calculation correctly.  

When investors talk about their cash on cash return, it is easy to get this confused with other "real estate return" terminology.  One thing to remember about cash on cash return is that it is a return calculation that is only done in year 1.  It can only be done in year 1 because after year 1, the time value of money would need to be taken into account.  Then the calculation becomes an entirely different calculation.  So the first important thing to understand about cash on cash return is that this is a calculation that is done in year 1 and not subsequent years.  

Cash on Cash Return = Year 1 Net Cash Flow / Year 1 Initial Cash Invested

Calculating Net Cash Flow

As was stated earlier, cash on cash return derives its name from the fact that it's calculated by taking year 1 net cash flow, divided by initial cash invested in the property.  Let's talk about how net cash flow is calculated.  To calculate net cash flow, first calculate gross income by taking one month's rent times twelve, and then subtract any vacancy allowance you might expect.  Vacancy allowance is just what it sounds like...it is a way to be conservative and adjust for possible problems finding people to rent to.  

Next, you'll need to subtract estimated expenses from rent.  There are many places expenses can come from but a few might include HOA fees, property taxes, property insurance, utilities, and repairs and maintenance.  Projecting these is not always easy, but if you are able to find experts in each respective area, you might be able to get more accurate estimations.  For example, talk to an insurance agent to get an estimate on property insurance.  And property taxes can be easy to estimate by visiting the county tax assessor's office.  

Once expenses are subtracted from gross rental income, this equals your EBITDA or earnings before interest, taxes, depreciation, and amortization.  In order to calculate net cash flow, interest and taxes still need to be subtracted.  Depreciation does not need to be subtracted because it is a "non-cash" expense.  By "non-cash" expense, that means depreciation is an expense that is allowed by the IRS but doesn't cost actual money.  However, depreciation will be needed to calculate income tax expense.  

First, let's subtract the mortgage interest expense from EBITDA.  Because mortgage interest is a pure expense that gets paid to the bank, this must be subtracted to arrive at net cash flow.  A simple mortgage calculator should provide a breakdown of principal and interest in year 1 in order to make this much more simple.  

Next, subtract depreciation expense.  As was stated earlier, this isn't an actual cash expense, but it needs to be subtracted before property income taxes can be calculated. (After taxes are calculated, depreciation gets added back in)  Once depreciation is subtracted, multiply the result by your estimated marginal tax rate.  This result is an estimated property income tax in year 1.  After subtracting the property tax expense from income, add depreciation back to your income.  

This is almost the final net cash flow calculation but there is one more thing to factor in.  That one thing is mortgage principal.  Mortgage principal is not considered an expense since principal payments go towards a property's equity.  And so it would seem unnatural to deduct principal payments from income and if this was a net income calculation, that would be true.  But this is a "net cash flow" calculation and since principal is paid purely to equity(and not cash), it cannot be considered cash flow in the truest sense of the term.   Therefore, it must be subtracted in order to calculate final net cash flow.  

Net cash flow can be confusing so here is a formula version of the calculation with the bullets representing steps in the process:

  1. Gross Income(including vacancy allowance) - Operating Expenses = EBITDA(Earnings before interest, taxes, depreciation and amortization)
  2. EBITDA - Interest Expenses - Depreciation = EBTA
  3. EBTA x Marginal Tax Rate =  Estimated Property Income Taxes
  4. EBTA - Estimate Property Income Taxes = Net Income
  5. Net Income + Depreciation - Mortgage Principal Payments = Net Cash Flow

 

Calculating Year 1 Initial Cash Invested

Initial cash invested is not as extensive of a calculation as net cash flow but it's just as important since it's the denominator in the cash on cash return formula.  Initial cash invested can be calculated by determining what your down payment on the rental property was followed by adding any cash expenses that may have been incurred in the property purchase.  

These cash expenses other than the down payment might include brokerage fees, renovation expenses, or appraisal costs as examples.  The larger your initial cash invested, the smaller your cash on cash return will be.  Sometimes a smaller cash on cash return can be due to a larger down payment being made which is not necessarily a bad thing if a larger down payment fits better within your asset to debt ratio risk tolerance.  

Pairing Cash on Cash Return With Equity Build Up Rate

Cash on cash return can and should be used in conjuction with a calculation called equity build up rate.  Another article discusses how the equity build up rate calculation is made, but from a high level, equity build up rate is a rate calculated by dividing mortgage principal paid in year 1 by initial cash invested in the property in year 1.  This can be added to cash on cash return to determine an investor's total return from the property investment in year 1.  

Conclusion

Cash on cash return is calculated by dividing net cash flow in year 1 by initial cash invested in the property in year 1.  As you can see from above, this calculation can be somewhat involved, however it is a great calculation to understand when comparing rental properties or other real estate investments.