In this article, we’ll teach you how to calculate cash-on-cash return—and why it’s one of the most important calculations for real estate investors.
Much of the real estate industry, including investors and agents, use this formula (sometimes called the equity dividend rate) as a quick way to analyze an investment’s cash flow.
More specifically, it calculates a percentage value based on how much money you’re making (or going to make) divided by how much money it takes to acquire the property.
We’ll go over what the metric tells you, as well as what it doesn’t tell you. It’s just as important to know when not to use this metric, because you don’t want it to influence you to make a deal that, upon more extensive review, actually isn’t that great. And, the next time a realtor tries to sell you on a property that has a “fantastic” cash-on-cash return, you’ll be better equipped to determine whether or not it’s as good as it sounds.
This should be one tool in a toolbox of other important metrics and formulas that you consider when looking at a deal. It shouldn’t be the only tool.
With that said, let’s get started.
Cash-on-cash is a simple formula: income earned divided by cash invested. It’s a pre-tax figure that takes place over the course of a year.
The easiest way to explain it is probably through an example.
Let’s say you buy a single-family rental property for $300,000. You put $60,000 down and the seller covers closing costs. The property has a tenant inside who’s renting the place for $2550/month. After factoring in all of your expenses (mortgage, maintenance, insurance, etc), you find out the property generates about $300 per month in positive cash flow.
You also need to factor in vacancies and subtract that from the total cash flow. For the purposes of this short example, let’s assume that this property is located in an in-demand area and the tenant has no plans on leaving any time soon. For reference, though, the average vacancy rate is about 6.8%. It’s up to you to know what it is in your market area.
So, to find out the cash-on-cash return, you’d take the income earned, $3600* and divide it by the cash invested, $60,000.
The result is 0.06, or 6%. You could also use a cash-on-cash return calculator, to make it easy.
All in all, the formula (or formulas, for each variable) looks like this: Annual Pre-Tax Cash Flow / Total Cash Invested
Annual Pre-Tax Cash Flow = (Gross Rent + Other Income (think parking spaces, pet fees)) - (Expenses + Vacancies + Mortgage Payments)
So, what does 6% even mean, then? Is it good or bad? Should you invest or skip out?
Cash-on-cash returns give you a fairly easy way to compare different investments, as long as you know how much income they generate and how much they cost to maintain. For example, let’s say you find another tenant-occupied property that’s selling for $190,000 and generates $205/month in cash flow. On the surface, it doesn’t seem like it would be very easy to compare the two. Your gut might tell you that the less expensive property is the better investment, or your gut might tell you that the property that generates the most income is the best investment.
What’s worse is that, in the real world, there are more than just two properties that look like this (and a lot of them don’t cash flow).
So, let’s calculate the return of the second property. In order to purchase the rental, you put 20% down. In this case, that’s $38,000. After closing costs, you end up paying $42,000.
The result is .058, or 5.8%. That means this property, according to this formula, is a slightly worse investment than our first example.
But what if you only had to put 10% down? And let’s imagine you get a good deal on private mortgage insurance so it only costs $50/month. Your annual pre-tax cash flow is $155/month or $1,860/year. After closing costs, you spend $23,000 to acquire the property.
So, annual pre-tax cash flow ($1,860) divided by total cash invested ($23,000) gives you 0.08, or 8%. Using leverage, you completely changed the numbers.
This way, you can easily compare different investments -- even if changing one factor might change a lot of factors. Maybe you’re looking at investing in a REIT that’s projected to grow at 10% annually -- you might skip out on the rental property entirely.
One thing you may have noticed, though, is that in our examples above, the tenant covered 100% of the mortgage payments. This formula ignores the fact that every time you make a mortgage payment you’re building equity. Instead, we’re only looking at how much money you have in your hands at the end of twelve months.
If we go back to our first example, with the tenant paying off a $300k property, the equity alone is desirable for many real estate investors.
Furthermore, taxes can completely throw off a deal. What if the taxes for the $300k property are the same as the taxes for the $190k property? If you’re just looking at this one metric, you’ll completely ignore that important variable.
Finally, what if you could buy a $200k property that generates $1,000 in annual cash flow by only putting 3.5% down (with the seller covering closing costs)? Total cash invested is a whopping $7,000, and your cash-on-cash return is 14.2%.
Buy, buy, buy! Right?
What if you got such a great deal on that property because it’s a waterfront that’s expected to be literally underwater in five years?
This formula makes leverage look fantastic. You might as well go out and scoop up as many rental properties as you can for as little money down as possible—but anyone who has watched some investors’ entire fortunes get wiped away by a downturn or some other unexpected event knows otherwise.
Cash-on-cash return, or equity dividend rate, is pre-tax cash flow divided by total cash invested. It tells you how much money you have in your hands at the end of the year.
It’s an easy way to compare different investments, particularly different rental properties and commercial real estate investments—and even stocks and bonds.
It isn’t perfect, though. The formula ignores equity, doesn’t take taxes into account, and makes leverage look greater than it is.
Make sure that, when you’re using this formula, it isn’t the only formula you’re relying upon.
Scott Royal Smith is an asset protection attorney and long-time real estate investor. He's on a mission to help fellow investors free their time, protect their assets, and create lasting wealth.
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