Real Estate Returns | Cash On Cash Return, Return On Equity, ROI, IRR
What is a good ROI in real estate? To begin to answer this question, the first thing to do is to understand how returns on investment properties are measured.
There are several ways to measure the rate of return on rental property.
The first is the cash on cash return. The cash on cash return is generally used in marketing investment properties to demonstrate the cash yield at the end the first year of ownership.
The second rate of return used is the internal rate of return (IRR). The internal rate of return is a more sophisticated measure of return that indicates a rate of return over multiple periods of time.
It's helpful to also understand the meaning of return on investment (ROI) and the meaning of return on equity (ROE). This is because the terms as used in the diverse investment real estate and brokerage industry may vary from their definition in classical finance and accounting.
How To Calculate Returns On Real Estate Investments
Return on Investment, Return on Assets, and Return on Equity
Before we begin discussing the cash on cash return and IRR of investment properties, its important to understand what could be meant by return on investment (ROI) in the broader investment arena. ROI may refer to the return generated by the total asset value of an investment (as if there were no debt). This is defined as the return on assets (ROA).
ROI may also refer to the return on the cash investment or equity owned by investors. This is referred to as return on equity (ROE).
It's important to note that ROE as noted above is not the same as cash on cash return as discussed next, even though sometimes cash on cash return is referred to as ROE. One key distinction is cash on cash return uses Pre-tax Cash Flow from the Pro Forma Cash Flow Statement, not an actual Net Income.
What Is Cash On Cash Return In Real Estate?
The Cash On Cash Return, measures the pre tax cash return as a percentage of the initial cash or equity investment made in an income producing property. The cash on cash return tells us the resulting cash after debt service a rental property will yield at the end of a year of operation as a percentage of cash put down to acquire the property.
In addition to ROE, the cash on cash return may also be referred to as the equity yield rate or equity cash yield.
The cash on cash return is calculated from the Pre Tax Cash Flow projected for the first year of ownership calculated in the Pro Forma Cash Flow Statement.
Pre-Tax Cash Flow = NOI - Annualized Debt Service
What Is The Cash On Cash Return Formula?
The cash on cash formula divides the Pre Tax Cash Flow by the initial down payment or equity invested in the property. The resulting percentage is the cash on cash return.
Cash On Cash Return =
Pre-tax Cash Flow
Equity Invested
Levered Cash On Cash Return
It is important to note the impact leverage has on the Return On Equity and the Cash On Cash Return. Positive leverage increases the return on the equity invested. It means, while using leverage, the return on the equity portion contributed to acquire the investment property is greater than the total return of the property. Conversely, if the property is negatively leveraged, this would be detrimental to the investor. It is therefore important to pay close scrutiny to the cost of borrowing and the price of the asset.
IRR vs. Cash On Cash Return In Real Estate
There are key differences between the IRR and the cash on cash return in real estate. The cash on cash return is generally a single period measure of return. It is simple and considers only the two cash flows: The 1) initial equity investment, and 2) the first years pre-tax cash flow. The cash on cash return does not apply the concepts of discounting or time value of money.
The internal rate of return can be used for multiple periods and considers the multiple cash flows throughout the holding period. The IRR is based on discounting cash flows.