In the commercial real estate industry, investors commonly use a metric called the cash-on-cash return in order to measure the cash flow that they receive for their commercial properties. This rate of return measures the amount of cash that has been earned on the amount of cash that the investor actually has invested in the property. The formula to calculate the cash-on-cash return is straightforward, but calculating the variable used, including the annual pre-tax cash flow and the actual amount invested, may be more complicated.
Calculating the cash-on-cash return
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The formula for calculating the return is simple. People simply divide the annual pre-tax cash flow of the property by the actual cash invested, and multiply it by 100 percent. This metric gives a much more accurate measure of how an investment is performing as compared to calculations that are based on the property’s return on investment for transactions involving long-term debt borrowing. It helps investors to predict whether or not they might expect regular cash distributions from the property over its life. Because it is a targeted metric, it can offer investors insight into whether or not they might expect a particular investment to pay them cash dividends while they own it.
Calculating the annual pre-tax cash flow
The formula that is used to calculate the annual pre-tax cash flow of a property is a bit more complex, and it involves several variables as follows:
Annual pre-tax cash flow = gross rent + other income – vacancies – operating expense – annual debt service
Each variable that is used in the formula has its own calculations involved.
1. Gross scheduled rents
The gross scheduled rent of a property is the gross monthly rent of the property multiplied by 12, which is the maximum income that might be received from it.
2. Other income
In addition to gross rents, many commercial real estate properties have opportunities for investors to derive additional money. For example, some include parking spaces at additional fees. Others allow pets with nonrefundable pet deposits. Investors will want to take into account all of these additional sources of income and add them to the gross scheduled rents in the formula.
Investors who are evaluating a property in order to determine whether or not to invest in it will want to include the potential vacancy rate that they might expect. Owners who already own the properties will use their actual vacancies by taking the number of days that the properties’ units were vacant times the daily rents and use that amount in the formula.
Investors who are considering a purchase can investigate the projected vacancy rate by contacting real estate agents and asking them to analyze how long a particular unit stayed on the market before it was leased. Investors can then divide this number by 365 to get the vacancy rate. For example, if a unit stayed vacant for 50 days, then the vacancy rate would be 13.69 percent. This could then be rounded up to 14 percent. The percentage is then multiplied by the gross rents for the property, which will give a projection for the vacancies that the investors might expect.
4. Estimating operating expenses
In order to estimate the operating expenses for a property, investors should include repair costs, property management expenses, taxes, insurance, bank fees, HOA fees and maintenance costs.
5. Annual debt service
The annual debt service includes the monthly payment for the principal and the interest on the building. It doesn’t include the taxes or insurance on the property, however, as those are included in the property’s estimated operating expenses.
By including all of these variables, the pre-tax cash flow part of the cash-on-cash equation can now be plugged into the overall formula for the metric.
Calculating the actual cash invested
The actual cash invested in a property can be figured out by adding together the down payment, any closing costs and the pre-rental improvements and repairs that the investor would make before renting the property’s units. The down payment is simply the amount that the investor had to put down to secure the loan. The closing costs are only those that the investor was responsible for paying. If there are any improvements or repairs that will be made before the units are rented, the total costs should be included when the investors are calculating their actual cash investment for the cash-on-cash formula.
Understanding the benefits and shortcomings of this metric
This metric is beneficial for investors who want to compare multiple properties. It is relatively simple and straightforward, and it can be calculated quickly when investors have the correct information at their disposal. It is also easier to use than more complicated metrics such as the internal rate of return. One shortcoming of this metric is that it will not tell investors what their actual returns will be because of required down payments and the taxes that may be assessed. The return is not promised but is rather a targeted figure. It may still be useful for investors to get very close to what they might expect for their actual return on equity from a property.
Figuring cash-on-cash returns for properties may help investors determine which ones might be better choices. These metrics are also useful for property owners who want to track the performance of their buildings during the life of their investments in them. Cash-on-cash returns offer a quick and fairly straightforward way for real estate investors to create business plans for their properties and to give them a method of determining whether or not specific properties should be avoided.
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