Understanding the Cash on Cash Return in Commercial Real Estate

Understanding the cash on cash return in commercial real estate is important when you are evaluating investment real estate transactions. What is the cash on cash return and how do you calculate it for a commercial property? What are the nuances and limitations of the cash on cash return? In this article we’ll tackle these questions in depth and also provide some detailed examples along the way.

Cash on Cash Return Formula

Before diving into some cash on cash return examples, it is important to have a sound understanding of exactly what the term means. So, let’s start with the basics. First, here’s the cash on cash return formula as it is commonly used:

As shown in the cash on cash equation above, the cash on cash return is defined as cash flow before tax divided by the total equity invested. The cash flow before tax figure used in the formula is calculated on the real estate proforma. The total cash invested figure used in the above equation is the initial equity investment, which is the total purchase price of the property less any loan proceeds and transaction costs, plus any additional equity required.

Note that this is the cash on cash return formula as it is typically used. However, it is not uncommon to see variations on this definition. For example, the cash flow figure in the numerator of the equation above could be calculated using cash flow before tax as shown, but it could also be calculated using cash flow after tax, or it might be based on cash flow with leverage (debt) or without leverage. This is why it is important to clarify how terms are being defined, and most importantly, to make sure measures are consistent when making comparisons.

Cash on Cash Return Example

Next, let’s take a simple example to illustrate the cash on cash return. Suppose you are evaluating an office building with an estimated Year 1 Cash Flow Before Tax of $60,000. Also, assume that the negotiated purchase price of the property is $1,200,000 and you are able to secure a loan for $900,000 (75% Loan to Value). What’s your cash on cash return for year 1?

The calculation itself is pretty simple – your cash on cash return for year 1 would be the Year 1 cash flow divided by your total cash out of pocket, which equals 20%. So what does this cash on cash return mean? Using only the figures above, the cash on cash return tells you that your year 1 return on investment is 20%.

Cash on Cash Return Limitations

The cash on cash return is a simple measure of investment performance that is quick and easy. It can be a good starting point for quickly filtering out potential investment properties. But don’t be fooled by the many limitations of the cash on cash return.

Consider the following series of cash flows:

The year 1 cash on cash return in the levered example above shows a 3% cash on cash return. To find this simply take the end of year (EOY) 1 cash flow of $15,805 and divide it by the initial equity investment of $515,000.

But as you can see in the table above, the internal rate of return (IRR) is 10.71%. This suggests that according to a discounted cash flow analysis, the investment is actually much better (almost 4x better) than what’s indicated by the cash on cash return. If you were only using the cash on cash return as an investment filter, then you’d pass up this opportunity to earn nearly 11%.

The reason why the cash on cash return is so much lower than the IRR in the example above is because the cash on cash return ignores the other 9 years of operating cash flows in the holding period. Plus, it also ignores the reversion cash flow at the end of year 10 that comes from the sale of the asset. Without taking into account these additional cash flows that occur over the holding period, it’s impossible for the cash on cash return to accurately reflect the return characteristics of the property.

The same is true when looking at the unlevered example above. The cash on cash return in the unlevered series of cash flows above is 6.2% ($95,000 divided by $1,515,000), and the IRR is 7.51%. This series of cash flows doesn’t produce as big of a gap as in the levered example, but it’s still a difference. Without taking into account all cash flows over the holding period, the gap between the cash on cash return and the IRR will be unknown.

Keep in mind that this can work in reverse too. In the above examples the IRR was higher than the cash on cash return because operating cash flows grow over the holding period and the sales proceeds of the asset are favorable. But it could also be the case that many leases will expire a few years after acquisition, causing operating cash flow to decline and the final reversion cash flow to be lower. This could produce the opposite result where the cash on cash return ends up being more favorable than the IRR.

Cash on Cash Return vs IRR

As mentioned in the section above, the cash on cash return and internal rate of return (IRR) are two different measures of investment performance. The biggest difference between the cash on cash return and IRR is that the cash on cash return only takes into account cash flow from a single year, whereas the IRR takes into account all cash flows during the entire holding period.

Since the cash on cash return and the IRR are two different measures, which one is better? As always, that depends on your investment objectives. That’s why it’s useful to look at a variety of metrics for a property in order to make an informed decision.

Let’s take a look at an example that shows why using both the cash on cash return and the internal rate of return can be helpful. Consider the following two sets of cash flows:

In the top left example you can see that the cash on cash return is 10% in each year of the holding period. This is calculated by taking the cash flow of $10,000 in each year of the holding period and dividing it by the initial investment of $100,000.

The top right example on the other hand, has a 0% cash on cash return each year because it doesn’t produce any cash flow until the asset is sold at the end of the holding period.

But notice that both investments have a 10% internal rate of return. So, which investment is better? This ultimately comes down to your investment objectives.

Investment #1 produces stable, predictable, and perhaps taxable cash flows in each year of the holding period. Investment #2 produces no cash flow until the sale of the asset at the end of year 5.

As you can see, using the cash on cash return in addition to the internal rate of return can help quantify these differences to inform your decisions. Other metrics can also help paint the picture and show you the nuance of an investment. These metrics include the internal rate of return, net present value, gross rent multiplier, cap rate, operating expense ratio, equity multiple, and more.

Cash on Cash Return vs ROI

What’s the difference between the cash on cash return and return on investment (ROI)? In order to understand this difference, it’s first important to clarify what ROI means. ROI is a common term used in business and investment. But the term “return on investment”, or “ROI”, can also be defined in various ways which sometimes makes it confusing to understand.

One way return on investment or ROI can be defined is that it’s the total gain of an investment divided by the total cost of the investment:

For example, suppose an investor purchased a parcel of land for $1,000,000, sold parking access each year during a large event to break even on all operating costs, and then after 2 years sold the investment and received net sales proceeds of $2,000,000. Using this method of calculating ROI you would end up with a return on investment that look like this:

($2,000,000 – $1,000,000)/ $1,000,000 = 1 or 100%

Of course, if this is how you are using ROI, then the cash on cash return would not be the same. The reason why is because the above ROI formula uses total gain and cost over the entire life of the investment, whereas the cash on cash return only measures the return from a single period’s operating cash flow.

Another common way ROI is defined is that it’s net income in a particular year divided by the cost of the investment:

For instance, suppose we have the same example above where an investor buys a land parcel for $1,000,000, operates at breakeven, and then receives net sale proceeds for $2,000,000 at the end of year 2. If we were to use this net income based variation of the ROI calculation, then we could calculate our ROI for year 1 like this:

$0/ $1,000,000 = 0 or 0%

In other words, our year 1 ROI is 0%. This is the same result we’d get with a cash on cash return calculation for year one and is subject to the same limitations discussed above.

At a high level, return on investment simply measures cost versus benefit. However, as discussed above, how “cost” and how “benefit” are defined will impact the results you get from an ROI calculation. That’s why it’s best to clarify terms and definitions so you can be sure you are speaking the same language and ultimately comparing apples to apples.

Cash on Cash Return vs Cap Rate

What’s the difference between the cash on cash return and the capitalization rate? The cash on cash return and the cap rate are two different measures of investment performance. While both the cash on cash return and the cap rate are based on cash flow for a single year, each ratio uses a different measure of cash flow, and therefore the cash on cash return and the cap rate measure two different things.

The cash on cash return uses the cash flow before tax line item on a proforma, which is then divided by the total equity invested. The cap rate, on the other hand, uses the net operating income (NOI) line item on a proforma, which is then divided by the purchase price.

In other words, the cash on cash return is the return to the equity owners because it takes the cash flow available to equity holders and divides it by the total equity invested.

The cap rate on the other hand, is the return on the property itself because it takes the net operating income from the property and divides it by the purchase price.

Although the cash on cash return and the cap rate measure different things, the cash on cash return is commonly used by appraisers to calculate a cap rate.

This is accomplished by using what’s known as the band of investment method. The band of investment method takes a cash on cash return and a mortgage constant and then uses these factors to build up to a cap rate.

This is particularly useful when there is no market data available for comparable sales, which is common in secondary or tertiary markets, or when a market crash causes transaction volume to freeze up.

To calculate a cap rate using the band of investment method, appraisers will survey local investors and ask them what their required cash on cash return would be to invest in the subject property. Then the appraiser will survey local lenders and ask them what terms they would be willing to lend on for the subject property, which can be used to calculate a mortgage constant.

Using this survey data, the appraiser can then create a weighted average between the cash on cash return and the mortgage constant in order to calculate a cap rate.

For example, suppose we survey local lenders to find out their current loan terms for a property similar to the one we are evaluating. We learn that we can get a loan at a 75% loan to value ratio, amortized over 20 years, at a rate of 6%. We can now use this loan information to calculate a mortgage constant of 0.085972.

We also survey local investors and find out that they would on average need an 11% cash on cash return to consider investing in a property like the one we are evaluating.

Now we have everything we need in order to calculate a capitalization rate using the band of investment method. To do this we simply take a weighted average of the return to the typical lender and the the return to the typical investor. In this case it is (75% * 0.085972) + (25% * 11%), which equals 0.06448 + .02750, or 9.20%. This is our market based cap rate rate using the band of investment method.

Does Cash on Cash Return Include Principal?

The cash on cash return is based on the cash flow before tax line item on a real estate proforma. The cash flow before tax is calculated after deducting the loan’s debt service and in this sense it does take into account both the principal and interest payments from a loan.

However, the cash on cash return does not take into account any principal paydown that occurs over the term of a loan. For example, if you have a $1,000,000 loan at a 5% interest rate amortized over 20 years, then your annual debt service would be $79,194. And your loan balance after 10 years would be $622,215. That means you would have paid down the principal balance on your loan by $377,784 over 10 years ($1,000,000 – $622,215). Since the cash on cash return is based on a single year’s operating cash flow, it does not take into account this principal paydown over the term of the loan.

The advantage of using the internal rate of return is that the IRR does take into account this principal paydown in the form of your net sale proceeds. The net sales proceeds is simply the selling price of the asset, minus any transaction costs, minus any remaining loan balance.

This doesn’t mean the cash on cash return should be ignored. It just means that it shouldn’t be the only factor considered. Using the cash on cash return along with other metrics will help show the nuance of the opportunity.

Conclusion

In this article we discussed the cash on cash return in depth. We defined the term cash on cash return, including how the formula can vary in different situations. Then, we discussed some limitations of the cash on cash return and reviewed how the cash on cash return compares to the internal rate of return, capitalization rate, and return on investment. Finally, we discussed whether or not the cash on cash return calculation includes loan principal. The cash on cash return is a commonly used metric in commercial real estate, but it is not a silver bullet. As such it is important to consider its limitations and nuances as discussed in this article.