A Guide for Commercial Real Estate Investors
Attend any real estate networking event and you’re bound to encounter a whirlwind of real estate jargon and acronyms like ‘cash-on-cash return’, ‘cap rate’, IRR, ROI, and more! As a commercial real estate (CRE) professional, you thought you understood these terms, but you’d love a handy guide with the most important ones explained in plain English.
This guide will unpack one of the most popular financial metrics used by CRE investors to measure the returns on an investment property: cash-on-cash return.
What is Cash-on-Cash Return?
‘Cash-on-cash return’ is a measure of the income earned on the cash invested into a commercial real estate deal.
It is calculated by dividing the annual cash flow from the property by the amount of actual cash invested. Cash-on-cash return is expressed as a percentage.
Investors can use this metric to easily compare business and investment opportunities against each other. A higher cash-on-cash return means a better investment.
Cash-on-cash return is also referred to as ‘cash yield’.
How to Calculate Cash-on-Cash Return
Caption: Cash-on-Cash Return = Annual Before Tax Cash Flow/Total Cash Invested To-Date x 100
The formula for calculating cash-on-cash return is:
Cash-on-Cash Return = Annual Before Tax Cash Flow/Total Cash Invested To-Date x 100
Calculating cash-on-cash return doesn’t have to be difficult. There are several online cash-on-cash calculators that you can use to make your life easier.
Example 1: An Investor Puts in a Down Payment of $200k on a $1 Million Loan
An investor uses a bank loan to buy a property for $1 million. To get that loan, the investor had to put in $200,000 as a down payment (this is their cash investment). The deal has an ROI (net profit / cost of investment) of 10%. The property produces an income of $50,000 per year (after paying all expenses except taxes).
So, given that the annual 'cash income' is $50k and the 'cash investment' was $200k, the cash-on-cash return for this investment is 25% ($50k / $200k x 100).
Example 2: The Investor Reduces Their Down Payment
What if the investor from Example 1, only had to put in $100k as a down payment instead of $200k? Their cash-on-cash return would be 50% instead of 25%! That's doubling the return for the investor even though the profitability (ROI) of the property remains exactly the same at 10%. If someone only relied on the ROI metric, then they would miss the huge potential gains offered by reducing the down payment amount.
In essence, the cash-on-cash return is simply the percentage of income you make on your own funds or ‘cash’ that you put into a property deal.
Generally leaving less of your own cash in a deal is preferable as it means the money can be put to work elsewhere.
Why Real Estate Return Metrics are Important
Investors often sift through numerous potential real estate deals before making a decision. Financial metrics like cash-on-cash return provide an ‘apples to apples’ comparison that helps them to assess the financial value of the deal and make decisions more easily and quickly.
Anyone and everyone who touches a real estate deal should have a basic understanding of certain key return metrics relating to the property they are interested in. Apart from cash-on-cash return, other real estate return metrics include cap rate, internal rate of return (IRR), return on investment (ROI), and equity multiple (the same as ROI but different units).
Caption: Different ways of measuring rate of return in real estate
Ultimately, you are investing in real estate to make money, and so knowing the metrics helps you to assess how much money you will make from each deal. Some investors require a metric to hit a certain number before they even consider pursuing a real estate deal.
Aside from investors, it’s also important that governments (local and national) understand these metrics so that they know what potential businesses and employers are looking at, otherwise they don't know how to entice investment or optimize other economic aspects of their city.
Benefits of Measuring Cash-on-Cash Return for Commercial Real Estate
In some ways, cash-on-cash return is the most important return metric of them all, because it offers the simplest way to understand how much money you make on the cash you invest, and that is how most people tend to think about their finances and investments.
For example, if you had a total of $100k in personal savings sitting in the bank, a question you might ask is: How much money can I actually make by investing this $100k? Cash-on-cash return answers that question for you, whereas other return metrics may miss the mark.
There are other benefits to using the cash-on-cash return metric which include:
Property Selection
Cash-on-cash return allows investors to do a do quick comparison of potential real estate deals based on the financial information provided by the seller. For example, say an investor is choosing between Property A, which has a 10% cash-on-cash return, and Property B, which offers a 6% cash-on-cash return. They might prioritize Property A assuming all other factors are similar.
Factoring in the Cost of Financing
Unlike other real estate return metrics, the cash-on-cash return includes an allowance for debt and/or mortgage costs. For instance, if an investor borrows $700K at an interest rate of 4% to purchase a $1 million property, with a down payment of $300K, the debt service will impact the cash-on-cash return calculation. Let's say the annual debt service amounts to $28K; this cost is integrated into the analysis, providing a more realistic view of the return on the actual cash invested.
So, if a property involves long-term debt borrowing, as is common with CRE transactions, you’re able to calculate the actual cash return.
Gaining Insights into a Property’s Expense Profile
Properties with high expenses generally have lower cash-on-cash returns. These kinds of insights help investors to analyze and compare the advantages of potential deals, and also to look at ways to bring property expenses down.
Limitations of the Cash-On-Cash Metric
Cash-on-cash has its merits, but it may not be as helpful in certain situations. It can show how well an investment is doing currently, or show the performance over a single year within the investment timeline, but it doesn't offer any insight into what might happen with performance in the future. It also overlooks the potential cash flow from a future sale.
This metric focuses solely on the pre-tax cash flow relative to the equity invested and disregards the unique tax circumstances of an investment. It also ignores the overall profitability of the investment. Furthermore, it doesn’t take into consideration changes in value due to appreciation or depreciation. All of these can significantly impact an investment’s overall return.
It could exaggerate the returns if it includes a ‘return on capital (ROC)’ instead of a ‘return on invested capital (ROIC)’.
Lastly, cash-on-cash return does not consider the timing of cash flows. Investments with varying cash flow patterns over time can have the same cash-on-cash return, yet their true profitability may differ.
Other Useful Metrics for Calculating CRE Returns
Return on investment (ROI)
Return in investment (ROI) is a way to assess how profitable an investment is, after subtracting all costs. It shows the profit earned compared to the initial investment. Essentially, it measures how efficiently an investment generates profit.
Although the true ROI is realized only after selling a property, it's important to forecast it to evaluate how profitable your asset will be.
How to calculate it: Divide the net profit (current value of investment minus cost of investment) by the initial investment cost.
ROI = Net profit / Cost of Investment x 100
Example: An investor buys a property for $500k and sells it for $600k after accounting for $50k in expenses, the ROI would be calculated as: [(($600k - $500k) - $50k) / $500k] = 10%.
Net operating income
Net operating income (NOI) represents a property's annual income after subtracting operating expenses, but before taxes and financing costs. You can use it to assess your property’s income-generating potential.
How to calculate it: Subtract operating expenses from revenue generated
NOI = Revenue – Operating Expenses
Example: An office block earns $200k in rent annually and incurs $50k in operating expenses, the NOI would be [$200k - $50k] = $150k, providing a clear picture of the property's profitability before financing costs are considered.
Cap rate
The capitalization rate (cap rate) measures the expected annual return on a property. Use it to compare the profitability across different properties.
How to calculate it: Divide the net operating income (NOI) by the property’s current market value.
Cap rate = NOI / Current Market Value
Example: A property has an NOI of $100,000 and is valued at $1 million. The cap rate would be [$100k / $1 million] = 10%, making it easier to compare with another property valued at $800k with an NOI of $80k (Cap Rate = 10%).
Internal Rate of Return
Internal rate of return (IRR) measures an investment's long-term profitability by accounting for the time value of money. It encompasses ongoing rental income and eventual sale proceeds. In other words, it’s useful for long-term investment analysis.
How to calculate it: Find the discount rate that makes the net present value (NPV) of all cash flows from the investment equal to zero.
Internal Rate of Return (IRR) = (Future Value ÷ Present Value)(1 ÷ Number of Periods) – 1
Example: An investor projects cash flows of $10k annually over five years plus a $150k sale at the end. IRR would provide the annualized rate of return considering these cash flows and the initial investment.
Equity Multiple
Equity multiple is a useful calculation when you want to understand the overall return on your invested capital. If the equity multiple is greater than 1.0, it means your cash returns are more than your initial investment.
How to calculate it: Divide the total cash distributions by the total equity invested.
Equity Multiple = Total Cash Distributions / Total Equity Invested
Example: An investor puts $100K into a property and receives $300K in return over the investment period. The equity multiple would be [$300k / $100k] = 3.0, indicating the investor's returns are three times their initial investment.
Nominal returns
Nominal returns refer to the percentage increase in the value of an investment without adjusting for inflation. This straightforward metric measures the gross gains in investment value.
How to calculate it: Subtract the original investment value from the current market value and divide it by the original investment value.
Nominal Rate of Return = (Current Market Value − Original Investment Value) / Original Investment Value
Example: An investor who purchases a commercial property for $500k. After holding the property for five years, the market value of the property has increased to $650k. The nominal return is 30%, indicating that the investment's value has grown by 30% over the holding period.
Final Thoughts on Cash-on-Cash Returns
Commercial real estate investing can be a complex and competitive environment to navigate. Investors make guesses and assumptions as to the types of things that would be conducive to a strong investment - such as using a key investment metric like cash-on-cash return.
However, it’s not easy to find and identify good opportunities. That’s why having the right tools to help you discover and analyze opportunities can be very helpful.
GIS analytics tools like AlphaMap allow people to hunt for opportunities based on their assumptions. Additionally, these tools help people see patterns and opportunities that they wouldn't have known about otherwise.
Ultimately, it’s important to evaluate your investment decisions within a wider context of other investment return metrics, and available data. You won’t get all the answers from one metric only, but cash-on-cash return is indeed a good measure to start with.
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