It’s a question we’ve all asked ourselves: how can we keep our day jobs and still make extra cash? I’m telling you there is a way. Through making the right decisions in property investing you can easily earn extra income. All you need is one simple formula.
How cash-on-cash return works
In real estate investing, one of the most important tools in your arsenal is going to be cash-on-cash return. This is a good starting point, not only for newcomers but also for investors who are first scanning through properties.
Let’s see how it works. Investopedia, who are financial market experts, describe cash-on-cash return as a way to determine how a potential rental property will perform. It’s easy to calculate, all you need to figure out is the annual cash flow over the total cash invested, before tax.
Just have a look at the equation below.
Annual Cash flow (Pre-Tax)Total cash invested= Cash-on-cash Return
See what I mean? If you’re still unsure what you need to make this calculation, then here is a quick run down.
Pre-tax Annual Cash flow represents the rental income of the property in a year without including the operating expenses. These operating expenses include things like vacancy rate, maintenance, internet, landscaping and other costs.
Total cash invested refers to the cash you paid to make the property functional. This will include things such as the loan from the bank (without the payments or interest), the down payment, the rehab costs, repairs, closing costs, etc.
After you have divided these numbers you should multiply the resulting number by 100. This percentage is also known as the ratio, which tells you if the property will generate a favourable cash flow.
We’ll talk about what Mashvisor considers to be a good cash-on-cash return to aim for below.
However, you should keep in mind that there are some things the formula won’t be able to calculate. Realty Mogul, an international investing company, says that it doesn’t take into account things like appreciation, return on investment or tax benefits.
But still, it gives you a good idea of the ongoing and immediate return on the cash you invested. With it you can plan for how you will purchase the property and finance it by taking into account future spending and unexpected expenses.
What qualifies as a good cash-on-cash return
What exactly makes a good cash-on-cash return? It all depends on what you want to achieve. A good cash-on-cash return is one that is higher than the investment rate that you have set for your retirement or for your financial growth.
According to Mashvisor, a real estate data analysis company, the consensus is that you should aim for a ratio between 8% and 12%. But really, It all depends on the goals that you set and the decisions you make.
For example, if you want to save up for retirement, then you should be putting aside a certain amount of money per month. If you’re not sure how much this should be, you can use this retirement calculator to calculate this value.
I put in an example of a 33 year old with a monthly earning of R40 000. The calculator suggested that this person should be putting aside R7 000 a month. Therefore, if this person invested in a property with a total cash investment of R150 000 they should be looking for a cash-on-cash return of at least 4,67%.
To set your goals, start by asking yourself questions such as…
- What is your main goal – retirement, financial freedom, financial growth rate?
- Are you investing in a single or multiple properties?
- In which location do you want to buy the property?
- Will you be taking out a loan from the bank?
- What property type are you going to choose – apartment, duplex, house?
- Are you going to be collaborating with a rental company?
- Will the property require renovations or upgrades?
The choices that you make will ultimately affect the cash-on-cash return.
It’s also important to note that before making these decisions you should also consider your commitment to the property. Your goals should be a reflection of how much risk you’re willing to take and how involved you want to be in running it.
What happens when you take out a loan?
By now you’ve probably realised that if you want to invest in a rental property – you’re probably going to need a mortgage loan. Not many people have that kind of money lying around so if this is the case then you don’t need to stress. You can take out a loan and still end up with a good ratio.
It mainly comes down to two things – interest rates and the down payment. In a different post, Mashvisor warns how banks will normally ask for a down payment on a rental property loan. This can make up 10%-20% of the purchase price of the property, depending on the country.
Don’t let this get to you, as a larger down payment can actually result in a better interest rate. These will also be affected by the type of property that you are purchasing, so just be aware of this when you’re consulting with the bank.
Here is an example:
If a property is worth around R1 Million, then according to Property24 you can expect a monthly income between R6 500 and R8 000.
For this example, we’ll set the Pre-tax Annual Cash flow at R8 000 without the operating expenses.
For the Total cash invested, if you are taking out a loan then a down payment of 10% of the purchase price would be R100 000. Let’s put repairs, closing costs and other costs that may have been incurred at R50 000.
8000150 000= 0,053100 = 5,3%
This might be considered to be a low ratio, but if you’re starting out and don’t want to take as much of a risk then this could be a worthwhile investment. If you don’t agree, you can always keep looking until you find a rate that fits your goals and needs.
The benefits of using cash-on-cash return
There are different reasons why you may want to use the cash-on-cash return formula. According to Roofstock, a real estate investment marketplace, apart from calculating the profitability of a property, it can also let you figure out a number things.
- It makes you think of all the possible expenses that the property could produce before you purchase it. This way you can include these in your yearly business plan and not have to deal with unwanted expenses.
- You can use it to figure out the best way to purchase the property. Whether you decide to take out a loan or pay out of your own pocket will affect things like the interest rates and the cash-on-cash return.
For example, if you are not taking out a loan then this could lead to a lower ratio. Taking out a loan, on the other hand, could also lead to some issues such as reductions in the value of the property or additional costs made by the owner.
- It can help you decide whether it’s better to hold the property for a long or short period of time. For example, the longer the holding period the more flexible the ratio might be. Making these decisions beforehand can help you avoid and prepare for any number of issues.
The difference between IRR and ROI
Bear with me. We are going to go through some terms which may seem complicated, but are actually not.
These terms are here because with them you can get a better picture of a property’s overall performance. While reading about real estate investing you may have noticed two other terms, along with cash-on-cash return, popping up.
Internal Rate of Return (IRR) and Return on Investment (ROI). Cadence, an investment firm, explains that these two may sound the same but they are actually two different terms which are complementary to each other. ROI calculates the total return on the investment over its entire period.
Therefore, if you are looking to measure investments such as stocks then you will want to use ROI instead. With these types of investments you’ll want to not only include how much money you invested but also how much money has been made from it.
IRR is the most difficult to identify and can take up resources if you don’t have the software to calculate it. The difference, however, is that it determines the growth rate of a property over a year. Calculating it for over a year makes it easier when working with rental properties.
Cash-on-cash return, on the other hand, excludes debt and measures the return on the cash that was invested. This way you can have a more accurate estimate of the potential profitability of the property. After you’ve purchased the property, you can then use ROI or IRR to determine its future performance.
This formula is mainly used in real estate investing. It may, however, also prove useful for measuring the profitability of other investments over the period of a year.
That’s it! Now you know how, why and when you should use cash-on-cash return. With the formula, you can start your real estate investing career or side business. While it doesn’t take everything into account, it is useful not only for beginners but also for professionals. Don’t let yourself be overwhelmed by all the complicated terms and formulas in real estate investing. Start from the basics and take it from there.