Our previous post discussed the positives and negatives of using the capitalization rate to evaluate an investment. Similarly, another quick and easy calculation often used in commercial real estate is the cash on cash return analysis. The basic premise of the calculation is: what am I getting back from what I put in?
First year cashflow/initial investment = Cash on Cash return (%)
It’s a down and dirty calculation that can be used in just about any scenario and a great one to teach to kids. It works in commercial real estate, stocks, bonds, even lemonade stands. Yet the simplicity of the calculation also contributes to the lack of forming a complete picture.
Tax-free. Although an investor could calculate their tax implications and do an “after tax” cash on cash return, often the widely used formula does not take into account your tax situation. This is obviously an important piece of the puzzle, since there is a significant chunk (upwards of 36%) that is paid at the end of the year which alters your overall yield.
Limited timeframe. Similar to cap rate, the cash on cash return analysis only looks at your first year of the investment. Often times your first year is when you spend the most in expenses on capital improvements, tenant improvements or re-positioning the asset. This means that your first year calculations can be skewed and won’t give you a complete picture of a “stabilized” property.
Initial investment. Most often, the initial investment calculations are not the true acquisition costs. Most investors will simply look at the amount of money they believe they will need to put down to secure a loan, when in actuality, the true acquisition cost can be much more. They can include closing costs, unpaid property taxes, capital improvements, and various other soft costs.
Similar to capitalization rate, cash on cash return is a great tool to use when quickly evaluating a real estate deal, but should never be used as a determining factor. Always make sure that you understand your long term picture, investment goals, tax implications, and your exit strategy prior to pulling the trigger on a deal.