A rule of thumb measurement used for
analyzing return on an investment property
and calculated by dividing cash flow before
taxes by the initial investment.
Cash on cash calculations based on
before tax cash flows are most commonly
found in the Canadian marketplace, although
some real estate brokerages prefer after tax
cash on cash. The decision rests with
individual preferences, the range of
available data, and the needs of individual
investors in specific marketplaces.
Regardless, documented disclosure of
procedures and terminology should accompany
all calculations to ensure client
understanding of the method being used.
Cash on cash should be viewed as a
general comparison tool only as it does not
take into consideration the present value of
cash flow, any taxes payable on cash flow,
or any appreciation/depreciation in the
value of the property (which occurs when
calculating the internal rate of return).
However, cash on cash does take into account
gross operating income, operating expenses,
and annual debt service.
Example of Cash on Cash
Cash on Cash = Cash Flow Before Taxes ÷
Initial Equity Investment
Property A has a cash flow before taxes
of $47,300 and the investor has made an
initial investment of $235,000.
Cash on Cash = $47,300 ÷ $235,000
= 0.20 or 20%
The 20% reflects the cash flow in
relation to the equity invested. The
investor can compare cash on cash rates for
various properties in the decision-making
process.
Modified versions of cash on cash
calculations have recently appeared in the
marketplace. Selected brokerages have
adapted the cash on cash formula to include
debt reduction (principal payments made due
to mortgage amortization). The addition is
referred to as equity buildup. The modified
formula is frequently described as a
broker’s rate of return. The net result is
typically a more favorable rate of return
given the equity component. The modified
version also uses cash flow after tax but,
as referenced earlier, no universal pattern
exists.
Example
of Cash on Cash
(Modified)
Cash on Cash (Modified) =
(Cash Flow After
Taxes + Equity Buildup (Debt
Reduction))
Initial
Investment
Property A has a cash flow after tax of
$36,923, a debt reduction due to principal
payments on the mortgage amounting to $892,
and an initial investment of $173,961.
Modified Cash on Cash = ($36,923 + 892)
÷ 173,961 = .2174 or
21.74%
Occasionally, salespeople and brokers
(agents) may also include an estimate of
capital appreciation for the period under
analysis. Obviously, if capital appreciation
is included, an even more favorable rate
would be obtained. Proponents point out that
the amount should be net of all disposition
costs. Opponents argue that this
modification detracts from the original
purpose of cash on cash as a measure of cash
flow in relation to initial investment.
Neither equity buildup nor capital
appreciation represent cash flow, but are
simply assumptions that future cash flow
will occur.
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