There are two primary financial metrics when evaluating a multi-family investment opportunity. The first is Cash on Cash (CoC) and the other is Internal Rate of Return (IRR). Most non-real estate investors will seek to understand the return on investment (ROI) to evaluate the deal, however, ROI metrics will not work in analyzing real estate. In the world of real estate, Cash on Cash and IRR are the easiest metrics to evaluate an opportunity since you do not know how much profit you will make before selling the property, which is needed to determine the return on investment.
Let’s dig more into Cash on Cash Returns.
Cash on Cash is a rate of return calculated by dividing the pre-tax cash flow produced by the property, by the initial cash investment. This rate of return can also be called the cash yield and equity dividend rate.
Cash on Cash Formula: Annual Pre-Tax Cash Flow / Total Cash Invested
Cash on Cash gives a good feel for the immediate and ongoing annual return that a cash flow investor can expect. When evaluating a multi-family investment opportunity, the sponsor will provide annual CoC projections. If the property is a deep value add or opportunistic investment you may not see immediate Cash on Cash returns until the property is stabilized. You will likely see most of your returns at refinance or sell in this scenario.
CoC is an important step for an investor to measure property profitability. Notice the Cash on Cash return is based on pre-tax. If you are already experiencing low returns, the taxes may wipe out any potential returns on investment.
Cash on Cash Returns Scenario:
The purchase price of an apartment building is $6,400,000. The deal sponsor pays 20% of the total loan as a downpayment, or $1,280,000, and takes a mortgage in the amount of $5,120,000. In addition to the down payment, the sponsor puts aside money for capital expenses in the amount of $520,000 making the total cash invested at $1,800,000.
Year one total projected revenues is $962,326. The operating expenses for year one is $510,909, making the Net Operating Income ($962,326 – $510,909) equal $451,417.
You will then deduct mortgage principal and interest from the Net Operating Income. For our scenario, the principal and interest is $317,544, making the total annual pre-tax cash flow equal $133,873 ($451,417 – $317,544).
Lastly, divide the annual pre-tax cash flow ($133,873) by total cash invested ($1,800,000) to get the Cash on Cash return of 7.44%.
What is a good Cash on Cash Return? Prior to Covid-19 the typical CoC returns were 8% to 12%. In today’s environment a Cash on Cash of 6% to 8% may be more acceptable. Especially as most alternative investments are providing zero returns, and some investments are going negative as we see in our 401k and stock investment portfolios. In the case of the scenario above the 7.44% annual return is attractive in today’s environment.