When you’re evaluating a rental property, it’s not enough to just calculate the cash flow to see if it’s a good deal or not. One can always put a larger down payment, reducing their debt payment, and therefore increasing their cash flow. When looking at a buy and hold rental property, an investor needs to consider what the cash-on-cash return is for a property.
In this post, we’ll dive into how to calculate the cash-on-cash return and how this metric varies based on whether an investor uses financing or not.
Recap of Investor Joe
In Part 1 of our Buy and Hold Numbers post, we met part-time investor Joe who’s living and working full time in San Francisco. Joe is analyzing a single family home out in the Mid West that he can rent out for $1100 a month. Given Joe’s busy schedule and long distance from the property, he needs to rely on a property manager to handle the day to day operations of the property.
Here’s a quick summary of the cash flow we estimated last time using both a bottoms-up approach and when using the 50% rule to estimate expenses. For a more detailed description of the income and expenses you’ll find in your cash flow, check out Part 1.
|Cash Flow (Income - Expenses)||134||1,604|
|Property Management (9% of collected rents)||-99||-1188|
|Lease Fee (assume new tenant in 2 years)||-29||-350|
|CapEx Reserve (new roof in 5 years)||-83||-1000|
|Vacancy (1 month)||-92||-1100|
The objective of conducting a buy and hold analysis is to determine not only what the cash flow will be, but to also determine what’s the return on your invested capital?
If you’re only calculating a property’s cash flow, you only have half of the story. For instance, say you bought a property all cash and it’s generating $700 a month of cash flow. Was that a good investment? Well, that depends.
Unless you know how much you invested in order to receive $700 of cash flow a month, you aren’t in a position to say whether such an investment was good or not.
This is where the cash-on-cash (CoC) return comes in. CoC is expressed as a percentage and is a useful metric that quantifies the annual return of your initial cash investment.
One can easily calculate it using the following formula:
Cash-on-Cash Return = (Annual Cash Flow / Cash Invested) x 100
We already calculated the cash flow term in the above equation, but to estimate the return we’ll need to know how much cash will be invested?
The cash invested will depend on how the property is purchased. Let’s see how Joe’s return changes whether he’s financing his purchase or buying all cash?
Buying With a Loan
From Part 1, we know that Joe was considering a property that costs $90,000. Let’s say he’s planning to use bank financing to cover 80% of the purchase price, so he has to put down 20%, or $18,000. It’d be great if that was the end of it, but we have to also consider closing costs as well as any additional costs to get the property rent ready.
Closing costs will vary depending on the lender and the strength of the borrower, but in Joe’s case, let’s say his closing costs are approximately $3,000. Also, while the property was recently renovated, it still needs a fresh coat of interior paint and some clean up that adds up to about $1500.
In all, the total cash to be invested equals $22,500 ($18k + $3k + $1.5k). Therefore, the estimated cash-on-cash return would be 7.1% ($1604 / $22,500 * 100).
On the other hand, what if Joe had a large sum of money sitting in his bank account?
Also, he has a friend who insists that all debt is bad and that he should just buy the house with all cash. His friend argues that in buying the house with no mortgage, his monthly cash flow would grow a ton. How much? Well, by paying all cash he would no longer have a $387 monthly payment to make. This increases Joe’s cash flow to $521 a month or $6252 annually.
After hearing this argument from his friend, Joe’s leaning toward buying the house in all cash. Though just to be sure, before Joe makes up his mind he considers calculating the cash on cash return with this strategy.
As a cash purchase, the closing costs will be much lower since a bank won’t be involved. With bank financing, a large chunk of the closing costs go towards the loan origination fees, possible points to pay up front, pre-paid financing fees, and the cost of an appraisal. Some banks require borrowers to pay a full year of insurance up front as well as put into escrow additional cash reserves to cover taxes and insurance for 2 months. But with a cash purchase, much of these costs go away. Though a title transfer fee will still apply and an investor may still opt to have an appraisal done as well as a home inspection for their own peace of mind.
So in Joe’s case, with no bank involved, let’s assume his closing costs are reduced from $3000 down to $1500 since he’s paying all cash, but still wants a home inspection done.
The same $1500 of initial cleanup and paint to make the property rent ready as compared to a financed purchase still applies.
Joe’s total cash invested with this strategy would be $93,000 ($90,000 + $1500 + $1500). Joe’s estimated annual cash flow is $6252.
Therefore, his CoC (Cash-on-Cash) Return in using an all-cash strategy would be 6.7% ($6,252/$93,000 * 100).
Although the cash flow is significantly different ($1604 vs $6252), the cash on cash return (7.1% vs 6.7%) between both strategies have fairly similar results.
In Joe’s case, he has either option to pursue. So what does he do?
Purchase Using Leverage or Buy All Cash?
This is a hotly debated topic and deserves its own post.
I will briefly say that in buying all cash, the higher monthly cash flow will provide a greater safety margin to withstand any emergency or large repairs that may turn up. Whereas if one is heavily leveraging themselves so that the monthly cash flow is only about $100 or even less, then an investor can find themselves in a lot of trouble if a major repair unexpectedly shows up. Not to mention, if a property runs vacant longer than expected, the investor who’s financing will still need to continue making monthly mortgage payments whereas the cash investor will not.
Another advantage in purchasing with all cash is that cash offers tend to be much stronger. So a cash buyer may be able to purchase a property at a lower price than a buyer using financing.
On the flip side, financing allows an investor to leverage their money to buy even more real estate.
For example, let’s take Joe again. Instead of buying that 1 property all in cash for $93,000, let’s assume there are 4 exact properties like this one. He decides to buy all 4 with leverage putting 20% down. The total cash invested to pick up all 4 would be $90,000 ($22,500 x 4). The total annual cash flow would be $6,416 ($1604 x 4). The cash-on-cash return is still 7.1% (6416/90,000 x 100).
He now controls 4 properties valued at nearly $400,000 instead of just a single property valued at a quarter of that. A tenant living in each property paying rent and paying down your mortgage so that over time, you will own 4 properties free and clear. This is what leverage can get you.
There’s no right or wrong answer here.
Picking up properties using leverage or buying all cash largely depends on each investor’s personal situation, risk tolerance, and goals.
When running the numbers on a potential buy and hold investment, we have a more complete picture of whether a property is a good deal or not if we calculate the cash flow and the cash-on-cash return. These 2 metrics can be calculated quite simply using the equations below.
- Cash Flow = Income – Expenses
- Cash-on-Cash Return = (Annual Cash Flow / Cash Invested) x 100
For simplicity, we haven’t included the effect of taxes or principal being paid down by the tenants paying us rent. I’ll cover these details in a future post.