Why Cash-on-Cash Return is the New King of Real Estate Investing
By Gerald Tay (guest contributor)
In the last article, we talked about capitalization rates (cap rate), which everyone abbreviates as Net Rental Yield. Using it can be a bit tricky, because the determinant of a property’s value is the result of a certain assumed net income stream. How can an investor reconcile these two things in his head: the property value, and the cap rate?
If I bought something with an assumed prospective net income of $10,000for$1 million cash, you and I would both agree that the cap rate and my ROI on that purchase was 1%.
One of the things investors ask me about cap rates is: “Why is this the most relied upon metric for many property investors? If we’re going to end up putting DEBT on the transaction, doesn’t it make sense to look at the cash-on-cash return?”
Exactly!
Cap rates are not the only thing you should look at
Cap rates – the yield on the purchase price -are really the simplest measure of the income-producing characteristics of a property. It’s not the only thing you should look at. Other important factors include the property’s location, what the leases are, who the tenants are, and many other real property considerations.
The Cash-on-Cash return is a different statement. It’s not telling you about the property, whereas a cap rate is telling you the income generating ability of the property relative to the price you paid or will pay.
The Cash-on-Cash return is determined by dividing the annual cash flow of a property by the amount of cash put into the property (typically the down payment and closing costs.)
3 important things the Cash-on-Cash return reveals
The Cash-on-Cash return reveals three important things:
How you choose to finance it
Effect of the leverage
Element of debt risk
It’s a very useful and important piece of information for you. Well it’s a choice between eating your rice on a paper plate, a plastic plate, a silver plate or fine china… But the rice is still the rice. So you can think of the caprate as talking about the rice.
The Cash-on-Cash return is telling you about not just the rice but how it’s served to you and, depending on your circumstances, you may want paper plates or fine china (no right or wrong) — it’s where you dine at, what is your preference, what is your risk tolerance, and so forth.
Cash-on-Cash return also tells you your risk of holding debt – I’m at risk of not being able to repay the debt tomorrow if the number is too low. There’re all kinds of good and bad financing risks and leverage. The cap rate tells you about the property, not my decision on how to finance it.
The Biggest Lies of the Real Estate Industry (or maybe just a simple case of childish ignorance)
They skip any mention of the fact that your property requires paying off both monthly mortgage payments plus interest to the bank. Why would they mention only borrowing costs (interest) and not mortgage payments?
By excluding mortgage payments they attempt to improve the apparent returns. Well, it’s certainly a lot easier to sell a property with an ROI make-over.
Warning: One reason why investors lose money is because rental income cannot cover Debt Service.
Net Rental Yield: 3%
Borrowing Costs: 1%
Therefore, Property Yield = +2%
You see, the positive yield is only the tip of the iceberg. And unfortunately for the little guy…When he factors in monthly mortgage payments plus interest, and if the rental income cannot cover both, he’ll be going into negative (outflow) cash every month – on top of his other financial commitments! The property becomes a negative investment and a huge liability instead.
For the little guy, it’s like riding a raft in the ocean with a small sail and a tiny paddle. If interest rates go up, you get creamed by bigger mortgage payments. If you can’t afford to pay or pay on time, they foreclose you. His ownership may appear on the title deed, but the deed belongs to the bank. Hypothetically, the little guy is no more than a tenant for the bank (landlord), rather than a master of his property.
Now you understand why many gullible investors lose money in property.
TIP: “Due to a maturing market, the huge capital gains era is over, and Cash Flow is taking over as the king of real estate.” – Gerald Tay
Grasping the concept of Cash-on-Cash return
An investor purchases a property for $1,300,000.He obtains an 80% loan and makes a down payment of $260,000.Additionally, the buyer pays $50,000 in closing costs, for a total equity investment of $330,000.
In the first year, the property produces $42,000 in net income, and after paying the debt service of $37,000, the property’s annual cash flow is $5,000.
To calculate the investment’s Cash-on-Cash return, simply divide the cash flow by the total equity investment:
By comparing cap rate and Cash-on-Cash return, one can easily see that while the cap rate is 2.9%, the Cash-on-Cash return is only 1.5%. Unless the buyer is willing to put down more money as down payment, he’s using a great deal of leverage with potential negative cash flows– should rents fall and interest rates rise.
For unlevered investments, Cash-on-Cash return is redundant – if the whole investment is made in cash, all periodic returns will be Cash-on-Cash returns (excluding sale proceeds).The majority of real estate investments, however, are made with a combination of equity and debt, as positive financial leverage drives stronger returns.
Therefore, a prudent investor must investigate a property’s debt coverage ratio and overall rates of return, as they all influence the desirability of the investment.
Concluding Comments
Cash-on-Cash return specifically drills down to Return on Equity (ROE) invested, and only considers returns that are driven by the property’s net cash flow.Other metrics, such as Internal Rate of Return (IRR), take into account future cash events such as sales and income, as well as the effect of principal reduction on total project returns.These measures are all important when evaluating an investmentand will be discussed in future articles.
Lastly, Cash-on-Cash return is particularly essential because it is fundamental to value investing.In today’s real estate market, investors can no longer rely on future upside or exotic exit strategies to provide acceptable returns.Asset performance must be driven by projectable, secure cash flow– there is no better measure of cash-driven profitability than Cash-on-Cash return.
By guest contributor Gerald Tay, who is the founder and coach at CREI Academy Group Pte Ltd, an organization dedicated to empowering retail property investors with smarter investing philosophy and strategies. He is a full-time investor with over 13 years of solid experience in building his wealth through Property Investment and is financially wealthy today. Posted courtesy of www.Propwise.sg, a Singapore property blog dedicated to helping you understand the real estate market and make better decisions. Click here to get your free Property Beginner’s and Buyer’s Guide.
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