Investing in commercial real estate requires accurate analysis of profitability and returns to assist with the evaluation of each opportunity. The cash-on-cash return formula is a calculation commonly used by investors and retail real estate leasing brokers to provide valuable insight into a property’s return on investment (ROI). Below is a breakdown of everything you need to know regarding cash-on-cash returns.
Cash-On-Cash Return Formula
A cash-on-cash return is a simple formula that determines the annual return rate generated on a property compared to the amount invested. To discover the cash-on-cash return rate, divide the annual pre-tax cash flow by the total cash invested.
Cash-On-Cash Return = Annual Pre-Tax Cash Flow / Total Cash Invested
Breaking Down Cash-On-Cash Return
The annual pre-tax cash flow is deduced by subtracting vacancies, operating expenses and mortgage payments from the total amount of revenue generated from tenant lease payments and other forms of income from the current period. This number is the building’s net operating profit.
The total cash invested refers to the amount of money spent in cash throughout the current period. This includes the down payment, any additional closing costs, insurance premiums, maintenance and other various expenses.
As most commercial real estate investments demand long-term debt borrowing, the actual ROI differs from the yearly liquid return. Determining a commercial property’s cash-on-cash return rate provides a more precise portrayal of the investment’s current cash value because it does not consider debt. The cash-on-cash return rate can also be used to predict the potential cash circulation of a commercial investment opportunity. An investor may then extrapolate the resulting percentage to estimate expected returns on the life of their ideal investment.
Cash-On-Cash Return Example
Suppose an investor wants to assess a single-tenant property to gauge potential profit margins. The proposed lease outlines an agreement that requires the tenant to pay $80,000 in rent. The investor would ultimately pay $50,000 in mortgage payments, including interest premiums. The purchase would require a $90,000 down payment and $10,000 in closing costs from the investor. The annual pre-tax cash flow, in this case, is $30,000 (rent revenue – mortgage payments). The total cash invested in this scenario is $100,000 (down payment + closing costs). This results in a cash-on-cash return rate of 30 percent.
Limitations of the Formula
Though a cash-on-cash return provides valuable intel, its simplicity renders it limited in some regards. Not only does the equation exclude debt, but it also neglects any appreciation or depreciation on the property. Additionally, the cash-on-cash formula fails to account for potentialities such as risks and unforeseen maintenance costs. It’s important to understand that the cash-on-cash formula is best used to calculate simple interest and returns, or the total cash earned in relation to the total cash invested.
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