Cash On Cash Returns In Commercial Real Estate Investments
The definition of cash on cash returns can be simplified as follows; cash on cash return is a rate of return commonly used in multifamily and commercial real estate finance. It is calculated by looking at the amount of cash you invested compared to the amount of income you received over a specific time period, generally one year.
Simply, cash on cash return is calculated by dividing annual income by total investment. Cash on cash return is also called the equity dividend rate in certain cases. This is one of the most common return systems that can be found in the real estate industry. Referring to the example mentioned above, you can see it is a ratio, which is converted in to a percentage.
Knowing the formula, you should realize that the cash flow figure equals the net operating income of the property. Usual operating expenses should be deducted from the gross rental income. Then the answer should be divided by the equity investment to get the cash on cash return.
Income tax effects, resale implications, future cash flows, and loan principal deductions are not taken into consideration when we measure the cash on cash return.
The cash-on-cash aspect can be utilized to figure out the effects of leverage. In general, leverage is created by using a commercial mortgage loan to finance a portion of the property’s purchase value. For instance, assume an investor is able to secure a $600,000 mortgage loan on a $1,000,000 acquisition. Although debt repayment expenses like interest and other costs are going to occur, in this case a remarkably lesser investment is required and hence the additional expenses can be considered as worthwhile ones. Instead of buying a $1,000,000 property with $1,000,000 cash, you are buying it with $600,000 debt and only $400,000 cash and therefore your cash-on-cash returns will measure results on an overall investment that is the same size, but your cash outlay being significantly less.
This indicates if you can finance a greater portion of the property’s purchase value you can increase the cash on cash return. However, loans always involve a certain amount of risk. If the projected net operating income decreased substantially, the owner may be liable to make principal and interest payments or even, at some point, pay back the entire loan prematurely.
An investment in commercial real estate, of course, is a subject to be studied thoroughly prior to making any decision. Income taxes, possible risks, the amount of money to be borrowed, and the various financing alternatives available are the key components to consider before making a decision.