Cash-on-Cash Return (CoC)
A promising property: How fast will get the invested cashback?
- why you should use CoC metric
- how to calculate CoC with examples
- the drawbacks of using CoC
- differences between CoC and other investment metrics
- SWORP Tip!
Why use CoC metric
CoC, CCR, and cash yield. Cash-on-cash return metric has multiple names and even multiple ways to be calculated. Generally, it measures a property’s profitability by comparing annual cash flow to the total initial cash invested to acquire the property. In other words, it simply represents the physical cash you have in your pocket after a year relative to the cash you’ve invested.
Why should you use it when considering a property purchase? Because it is a useful tool to analyze new investment property's performance potential and to provide a review of returns on a certain property. CoC helps you to think ahead about the expenses associated with a potential investment property and it is a great indicator of the leverage effect because it only considers the net and compares it to the actual amount of cash invested.
Let’s imagine a cash-on-cash metric as a thermometer. It tells you if your body temperature is high, if you even have a fever, or if you are hypothermic on the contrary. However, the thermometer would not indicate what causes it, what is actually happening inside your body, or what affects the finding. Similarly, the cash-on-cash return indicates your ongoing income flow, but it won’t tell you how much you gain or lose overall or hint you about a property’s riskiness.
However, it certainly doesn’t mean that you should disregard CoC among other property investment metrics, because it gives you additional information on how lucrative an investment may be when comparing two or more properties. With this tool, you easily choose the property with the highest potential return. It aids you to decide which one of multiple properties would be the most promising potential investment, especially when you assess commercial properties which are accompanied by considerable debt, as CoC doesn’t take this debt into the account.
How to calculate the CoC
Ready for an easy-peasy equation? First, gather these numbers: net income after financing (no income taxes, you need an annual pre-tax cash flow/net cash flow), down payment, remodeling costs, insurance, and maintenance costs. Why are taxes excluded from the calculation? It is a key variable, right? Because it depends on income, which is almost unpredictable when you make an investment decision, and as it differs from property to property, you wouldn’t be able to compare the properties with the same meter.
STEP 1: Calculate the property’s net operating income (NOI). Find out, what your gross rental income would be - the maximum rent you would collect if your property was fully occupied for the whole year and your tenants would pay the full rent. Add any additional property income, such as parking and laundromat fees. Next, subtract expenses (operating expenses, mortgage payment minus insurance and taxes, vacancy loss). In case the property is new, use the potential vacancy rate (usually around 10%). What you come up with here is your annual pre-tax cash flow.
STEP 2: Continue with calculating your total cash invested, which is the down payment and any expenses such as repairs and maintenance the property has before you rent it. before the property is rented).
STEP 3: Build the CoC equation.
STEP 4: Multiply by 100 to get the percentage.
Example: Let’s say the annual pre-tax cash flow of your rental property is 2 000 000 CZK. When acquiring the property, your down payment was 6 000 000 CZK (out of 30 000 000 CZK purchase price). 2 000 000 / 6 000 000 equals 0,33. CoC of such property is 33%.
Good or bad?
Usually, you hear that more than 10% CoC (meaning the cash will return in 10 or fewer years) is reasonable for the risk you are undergoing, while less than 5% is a red flag. It is tricky to identify which CoC is good or bad because what you get out of the CoC formula may be interpreted misleadingly.
Example? Let’s play with the property above. The total purchase price was 30 million, but the actual cash you invested to acquire the property was only 3 million. Annually, you collect 2 400 000 in rent, count with 10% vacancy, repairs, maintenance, rehab - let’s say your net annual pre-tax cash flow is 1 400 000. 1400 000/3 000 000 is 0,47. CoC of such property is 47%.
Some crack opens a bottle of champagne. Wow, 47%! Incredibly high, almost half of the investment will return in just one year!
Here’s the catch: compared to the value and debt of this purchased property, your annual pre-tax cash flow is relatively low. Therefore, it will most probably suffer through every unexpected expense. The debt you owe might easily outweigh the property’s worth.
Drawbacks of using CoC
As cash-on-cash return depends heavily on income, it is consistent only as long as the income of the property is. In case the income increases (typically for rent raise), the cash-on-cash return goes up accordingly. On the flip side, if you need to finance unexpectedly costly repairs (new roof, elevator, etc.), the cash-on-cash return will drop. Also, don’t forget that CoC considers only a pre-tax cash flow, which may also be a game-changer in your investment decisions. Keep in mind that if the CoC is low, the taxes may critically diminish potential investment returns.
Generally, the biggest weakness you must count on using this metric is how limited the information you get from CoC is. CoC formula not only disregards taxes, but also debts and appreciation, and compound interest and doesn’t account for resale and cash flow in the future. On top of that, cash-on-cash may increase or decrease from one period to the next due to fluctuations in income, expenses, or additional cash invested.
So what to expect from cash-on-cash return calculation? Simply an overview of a property’s potential return at a given time, isolated from other economic factors. So it definitely shouldn’t be the only analyzing tool you use when making an investment decision, but one of several (such as ROI, CAP, NOI, and CF, which provide the much-needed context).
CoC comparison with other major investment metrics
- CoC vs. ROI: ROI measures the overall profitability of a property over the entire time it is owned, debt and cash included. Cash-on-cash only measures the return of the actual cash you invested when acquiring the property.
- CoC vs. IRR: We define IRR as the total interest earned on money invested. The IRR expresses the total income earned throughout the ownership. It also means that IRR calculation is vastly more sophisticated as it counts with the time value of money.
- CoC vs. CAP: CAP assumes that the property has no debts. If you purchase a property with all cash, the cash on cash return would be equal to the CAP. However, especially in the case of commercial real estate, most investors use at least some degree of leverage, so CAP and CoC can differ remarkably.