What Is The Difference Between Cash Flow And Net Income How to Use Cash-on-Cash to Compare Investment Opportunities

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How to Use Cash-on-Cash to Compare Investment Opportunities

In this real estate investment article, we want to discuss cash back by exploring its meaning, pros and cons, popularity among real estate investors, and then the cash back formula with a few examples.

So let’s begin.

The cash return (or equity dividend rate) measures the ratio between the property’s expected cash flow before tax in the first year (CFBT) and the amount of the real estate investor’s initial cash investment to purchase the rental property.

Here’s an idea: cash on cash is the percentage of cash flow relative to cash investment.

The popularity and use of cash in real estate investing is because it provides investors with an easy way to quickly compare the profitability of several investment opportunities. For example, an investor might compare the first-year yield on a cash-in-cash (or CoC) real estate investment with the yield a bank offers on a CD. In this case, for example, an investor might choose to invest his money in an apartment complex that returns a CoC of 7.6% instead of a CD that pays 3%, and vice versa.

Generally speaking, cash return is not considered a particularly powerful tool for measuring asset profitability because it does not take into account the time value of money. In other words, because it does not compound or discount money over time, CoC is limited to measuring the investment property’s cash flow in the first year of ownership only.

Regardless, the cashback is not without validity. It will certainly provide real estate investors with a quick way to compare investment opportunities and similar income producing properties.

How to calculate

Cash on cashback = annual cash flow / cash investment

What does that mean

Before we consider the example, let’s make sure we understand the components of the formula. This will be key for you to accurately calculate cash-to-cash in your rental property analysis.

1) Annual Cash Flow – This is cash flow before tax (CFBT) as opposed to cash flow after tax (CFAT). In other words, it’s the cash flow for the first year without adjusting for federal income taxes. CFBT is calculated by calculating annual rental income less annual operating expenses less annual debt service or loan payments.

2) Down payment – this is the total amount of initial money required to purchase a property and includes down payment, credit scores, escrow and title fees, appraisal and inspection costs.

Example

Okay, let’s calculate the cash back.

You are analyzing the profitability of a residential building with six residential units according to the following scenario. Each of the six units collects $1,000 a month. You estimate that operating expenses for the first year will be $28,800. Your mortgage requires $126,000 down, a credit score of $2,940, and a monthly loan payment of $1,956. You estimate your closing costs, ie escrow, title, inspections and appraisal fees, at $2,100.

First, calculate the annual cash flow:

Gross Projected Income $72,000 ((6 Units x $1,000) x 12)) minus Operating Expenses of $28,800 equals $43,200 (Net Operating Income) minus Mortgage Payment $23,472 ($1,956 x 12) = $19,728 Cash Flow

Then calculate your cash investment:

Down payment of $126,000 plus credit scores of $2,940 plus closing costs of $2,100 = $131,040 cash investment

Finally, calculate the CoC:

Cash Return = Annual Cash Flow / Cash Investment, or $19,728 / $131,040 = 15.06%

Okay, now let’s apply it.

You are trying to decide where to invest $126,000 in cash. You can invest it in a 3% T-bill at your local bank or, as you just discovered, you can buy a six-unit property with rental income and get a 15.06% cash-out return. What will you do next? You may want to do a full property analysis on the property and look at some other key returns and measures. Although on the surface real estate investing seems like the most prudent choice for real estate investment, you cannot make a decision without more information and a more complete analysis of the property.

But there is a caveat. Be sure to use credible property data for your analysis; confirm that everything the seller or agent gives you is complete and accurate; calculate all numbers and property data concisely and carefully.

With that said, here’s to your real estate investing success.

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