Cash on Cash (CoC) provides an easy way for real estate investors to quickly compare or measure the profitability of similar income-producing properties against another investment opportunity.
However, the Code of Conduct is not a particularly powerful tool for measuring the profitability of rental income properties and currently receives less attention in real estate investment analysis than it did a few years ago.
One of the shortcomings lies in the fact that cash on cash yield does not take into account the time value of money. The cash return on cash should be limited to just a measurement of the first year’s cash flow for the residential income property and not the cash flows for the future year.
However, cash is not without its validity and still offers seasoned and novice real estate investors an advantage that has always been attributed to its popularity.
The COC yield measures the ratio between the expected cash flow for the first year to the amount of the initial cash investment that a real estate investor makes to purchase rental property. Hence, the code of conduct is always expressed as a percentage.
The “first year cash flow” (or annual cash flow) is the amount of money the property is expected to generate during the first year of operation. An “initial investment” (a cash investment; sometimes called an acquisition cost) is the total amount of cash invested including down payment, insurance points, collateral fees, title, appraisal and examination costs.
Well, let’s start with an example and then do the math.
Let’s say you are interested in purchasing a property of six units that each pays $1,000 per month in rent. Operating expenses for the first year are estimated at $28,800. You plan to get a new mortgage with a down payment of $126,000, insurance points of $2,940, and a monthly payment of $1,564. You estimate that your closing costs (warranty, title, inspections, and appraisal fees) will be $2,100.
Equation: Annual cash flow / cash investment = cash over cash return
In this case, you will need to do five calculations (to determine annual cash flows and cash investment) before you can calculate cash on cash.
Annual Rental Income: (6 units x $1000) x 12 = $72,000
Net operating income (NOI, income minus expenses): $72,000 – 28,800 = $43,200
Annual debt service (mortgage payment): $156 x 12 = $23472
Annual cash flow (net operating income minus payment): 43,200 – 23,472 = $19,728
Cash investment (down payment + points + closing costs): $126,000 + 2,940 + 2,100 = $131,040
Calculation: (Annual cash flow / cash investment = cash on cash return) $19,728 / $131,040 = 15.06%
Now that you know that this specific investment opportunity yields 15.06% of your CoC, you can compare it to similar properties, or alternative investments like the T-Bill rate, and decide whether to keep buying.