There are many different metrics that can be used to measure a commercial property’s return. For example, the Internal Rate of Return (IRR) is used to measure a property’s compound annual return, the capitalization rate or “Cap Rate” is used to measure the annual return assuming an all cash purchase, or Net Operating Income can be used to measure the amount of cash flow that the property produces annually. While all of these are valuable metrics, none of them measure the return on cash invested in the property. For this measurement, it is necessary to use the Cash on Cash Return or “CoC return” for short.
In order to fully understand how the CoC Return works, it is first necessary to review how a typical commercial real estate transaction is financed.
How a Commercial Real Estate Transaction is Financed
Commercial real estate is expensive, which means that it is unlikely to be purchased with cash. Instead, a typical transaction is financed with a combination of debt and equity. Debt is the loan received from a lender and typically accounts for 60% – 80% of the property’s total purchase price. Equity is the upfront cash contributed from one or more investors and accounts for the remaining 20% – 40% of the purchase price, it is sometimes referred to as the down payment on the property.
Debt is useful because it minimizes the amount of capital that real estate investors must inject into the transaction and it tends to boost overall returns. But, return metrics that include debt are somewhat misleading in the sense that they measure the return on investment for the total transaction, including the debt portion. This is helpful, but some investors want to know the return on their capital only. For this use case, Cash on Cash return is the preferred metric.
What is Cash on Cash Return?
Cash on Cash return is a metric used to measure the income earned on a cash investment and the equation used to calculate it is:
While the equation itself is relatively simple, the components can be a little bit tricky to derive so it makes sense to discuss them individually.
In the numerator of the equation is “Annual Income Received / Cash Flow.” This may seem straightforward, but it is important to be very specific about what cash flow number is being used in the numerator. In most cases, it is the annual before tax cash flow, which is the money produced by the property after operating expenses and debt service have been paid. However, in some cases, an investor could use after tax cash flow, levered cash flow (cash flow with debt), and unlevered cash flow (cash flow with no debt). There is no “right” cash flow figure to use, but it is important to be clear about which one it is so that potential investment partners understand how the figure was calculated and so an accurate comparison can be made between multiple properties.
In the denominator of the equation, total cash invested represents the initial equity contributed to the project. An easy way to calculate this is as the purchase price, less the loan amount. In some cases, additional cash may be required for things like planned renovations or operational reserves, if this is the case these funds should be included in the total cash invested figure.
Cash on Cash return is calculated on an annual basis and an example is helpful to illustrate how it works.
Cash on Cash Return – An Example
Suppose that an investor is considering the purchase of a retail investment property. The asking price is $5,000,000 and they have received a loan commitment (debt) for $4,000,000 to fund a portion of the purchase. The remaining $1,000,000 will come from a cash injection – this is the denominator in the Cash on Cash return equation. To obtain the numerator, the investor has created a proforma financial projection for their anticipated 5-year investment holding period. It is summarized in the table below:
From the table, it can be seen that the property’s rental income, less operating expenses results in a figure known as Net Operating Income or NOI for short. From NOI, the loan’s annual debt service is subtracted, which results in a figure known as annual pre-tax cash flow, this is the numerator in the equation for each year of the holding period. When divided by the initial cash investment of $1,000,000, the annual cash on cash return is calculated. For the holding period shown, cash on cash return ranges from 6.50% in year 1 to 8.50% in year 5, which begs the question, what is a good cash on cash return?
The desired cash on cash return varies by investor. Depending on their individual preferences, risk tolerance, and capital needs, they may be more willing to accept a higher or lower return. However, in general, an annual cash on cash return in the 6% – 8% range is considered to be acceptable.
Limitations of Using Cash on Cash Return As a Primary Return Metric
The primary limitation to using cash on cash return only when evaluating a real estate investment is that it just measures the return for one year. In a typical CRE rental property investment, the cash flows are relatively small from year to year and the big potential profit comes from the sale of the property at the end of the investment holding period. For example, looking at the table above, assume the same annual cash flows for years 1-4, but then a large cash flow of $1,250,000 in year 5 when the property is sold. In this case, the resulting IRR is 10.18%, which is very respectable.
The point is this, an investor could look at the series of cash flows above and decide that a 6.50% return in year 1 is unacceptably low and pass on the deal. This is a mistake because cash on cash return alone ignores the powerful impact of the cash flows for the other 4 years in the holding period, including the big one at the end from the sale of the property. The impact of these extra cash flows shows up in the IRR of 10.18%. So, passing on the deal because of year one cash on cash return alone results in a missed opportunity to earn a higher return over the entire holding period.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
When evaluating potential properties for purchase, we always use the Cash on Cash Return as a tool for evaluating the deals. But, we don’t use it alone. We use it in conjunction with other important return metrics like IRR and Equity multiple to get a complete picture of the return potential.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
