By Terry Painter/Mortgage Banker, author of “The Encyclopedia of Commercial Real Estate Advice” – Wiley Publishers, Member of Forbes Real Estate Council
Cash on Cash Return is the most popular metric used by income property investors. It’s the net cash flow from a property annually divided by the total cash you put into the property. This tells you the percentage you are earning on your investment annually.
Annual Net Cash Flow/Cash Invested = Cash on Cash Return
Why is Cash on Cash Return so Important?
When we find an income property to purchase that turns our head, our minds are geared to think about Cash on Cash Return. It’s more like we become obsessed with “what percentage” we are going to earn annually – actually, more like monthly on our cash invested. Cash on Cash Return tells us that. Not too long ago just knowing that you could earn 8 to 10% on your money gave you that cozy feeling. But in this overpriced real estate market today, you get a sinking feeling in your stomach when you crunch the numbers and realize the cash on cash return will only be 2 to 4% on a multifamily property in a good neighborhood. Of course if you want to buy a C minus property in a rundown working class neighborhood, you can still earn over 8% on your money.
Surprisingly, It can still make sense to buy at today’s low yields if you go for the long buck instead of the short buck, and if you manage the 6 influencing factors that will improve your cash on cash return. I will be going into these 6 factors in this article along with why single-family-rentals are a DINOSAUR and why there has never been a better time to move up to commercial real estate. At the end I will tell you why you should just dump cash on cash return and focus on an entirely different metric called the EQUITY MULTIPLE that can double your cash investment in today’s overpriced market!
Calculating your Cash on Cash Return Accurately
To project your cash-on-cash return – take your gross annual rental income and subtract all annual expenses and the annual mortgage payments to come up with your net cash flow. This is your profit. Then you divide that by all the cash you put into the property. Be sure to include the down payment, closing costs and initial cash out of pocket costs for renovations to come up with your total cash invested.
6 Methods to Improve Your Cash on Cash Return on a Rental Property
1. Make the Down Payment as Low as you Can – The less you put down, the better the cash on cash return will be. Let’s say you are buying a duplex for $400,000 and putting 30% down which is $120,000. Now lets assume that the net annual cash flow after expenses and the mortgage payment is $9,600. That works out to be an 8% cash on cash return. Now let’s say you put only 20% down on the same property, with the same net profit, which is $80,000. In that case your cash-on-cash return is 12%.
2. Negotiate the Lowest Sales Price – One of the top tenets of investment real estate is that you make your money on the buy – that is to say by buying at below market value. With the shortage of rental properties for sale today, that is almost impossible to accomplish. So you are going to have to make your money over time on raising rents, lowering expenses and on appreciation. But without question, negotiating the lowest sales price will greatly improve your cash on cash return right out of the gate.
3. Choose Inexpensive Value Adds – When you are buying at today’s high prices, you just can’t afford to put too much money into renovations the first year. Why? Because it will likely cost more than you plan on, and this will greatly lower your cash on cash return by increasing your total cash invested. So try and stick with inexpensive value adds like painting the building, painting the cabinets, new window coverings, and rebranding which can just be a new name, new signage and a new website.
4. Finding a Property with Under Market Rents and Raising Them – Any amount you can raise rents your first year will go right to the bottom line and increase your cash on cash return. But beware! You also have to keep the property at full occupancy and make sure your tenants are paying the rent on time. Increased vacancy and poor rent collections can completely wipe out your profit from raising rents.
Multifamily properties for sale in good neighborhoods are averaging between 2% and 4% cash on cash return today but as long as you can raise rents over time there can be a great upside. According to Zillow, rents increased 10% nationally in 2021 and as much as 20.6% in places like Boise, Idaho. If you are able to increase your rents in one year by 10% which would raise the rent of a $1,000 per month apartment unit by $100, you can likely increase your cash on cash return from 4% to 8%.
5. Lower Expenses – Just as with rents, any amount you can lower expenses will go right to increasing your bottom line increasing your cash on cash return. Focus on the 4 largest ones: taxes, insurance, management and repairs and maintenance. Negotiate with the county for lower taxes, shop insurance competitively by shopping direct insurance carriers against each other, shop management companies against each other too, and get bids on major repairs, lawn and building maintenance.
6. Get the Lowest Payment Financing – You absolutely have to get the lowest loan payments possible. This means finding a loan with the highest LTV and lowest Debt Service Coverage Ratio (DCR) – the longest amortization and lowest rate. And try to get interest only payments.This can lower your loan payments better than anything and increase your cash on cash return.
Use the Equity Multiple as a Metric to Measure Your Return on Your Investment
The equity multiple is a metric that really makes sense in today’s overpriced rental property market. I’m talking about factoring in the appreciation that the property will be earning along with the net cash flow from operations to show your earnings. Even at today’s high sales prices, commercial properties are forecasted to double your cash invested in 5 years.
The equity multiple is the total profit the property has earned from operations and appreciation combined in a given number of years divided by your total cash invested.
Total Profit from Operations + Appreciation/Total Cash Invested = Equity Multiple
An equity multiple of 2 means you are doubling your cash invested. But in today’s market, you will need to hold the property for 4 – 5 years to realize this gain when you sell or refinance the property. Keep in mind that investment real estate most often earns more money from appreciation than from operations. So obviously, you are going to have to rent during this hold period. Since the eighteen eighties, real estate has always gone up in value in America – though it always has peaks and valleys keep in mind.
