Cash-on-Cash Return

Cash-on-cash return is a measure of the annual cash flow relative to the total cash invested. By providing you a rate of return, this metric helps you compare apples to apples when considering real estate investing versus other investment vehicles. To calculate:

1. Determine annual cash flow (monthly cash flow multiplied by 12)
2. Divide by total cash invested (down payment, closing costs, repairs/renovations, etc.)
3. Multiply by 100 for percentage

For example:

Purchase Price: $250,000

Down Payment (20%): $50,000

Closing Costs: $6,500

Repairs: $3,500

Total Cash Invested: $60,000

Monthly Rent: $1,750

Operating Expenses (mortgage, taxes, insurance, vacancy, misc repairs): $1,325

Monthly Cash Flow: $425

Yearly Cash Flow: $5,100

(Yearly Cash Flow (5,100) / Total Cash Invested (60,000)) x 100 = 8.5% cash-on-cash ROI

A good cash-on-cash return is typically 8-12%, though this can vary by market. On the surface this may appear comparable with stock market returns, however, this is purely looking at cash flow. This does not take into consideration: tax write-offs, appreciation, loan paydown, equity build-up, and the use of leverage.

Capitalization Rate (Cap Rate)

Cap rate indicates a property's potential return, regardless of financing. Essentially, it is the return on investment as if you had paid cash for the property. This metric is more commonly used in commercial transactions but it applies to any real estate investment. To calculate:

1. Determine net operating income (NOI)
2. NOI = Annual income - Operating expenses (excluding mortgage)
3. Divide NOI by property's purchase price
4. Multiply by 100 for percentage

Higher cap rates generally indicate higher potential returns, but also higher risk. Lower cap rates typically suggest lower risk but also lower potential returns.

For example, if a property worth $500,000 generates $25,000 in annual NOI (annual income - operating expenses), the cap rate would be ($25,000 / $500,000) x 100 = 5%.

For newer investors, I personally believe that you are better served learning to evaluate a property based on its cash flow and cash-on-cash return. This is especially true if you plan to purchase an investment property with financing, as cap rate does not take that into consideration.

The 1% Rule

The 1% rule is a rule of thumb. I am wary to share this one because in certain areas it is very rare to find a property that meets the 1% rule, and just because a property does not meet the 1% rule does not mean that it will be a bad investment. This quick evaluation tool suggests a property's monthly rent should be at least 1% of its purchase price. While not foolproof, it can help quickly screen potential investments.

For example, if the property's estimated monthly rent is $1,500, and it will cost you $350,000 to purchase, then it does not meet the 1% rule. $1,500/$350,000 = 0.43%. More than likely this property will not cash flow if you take debt service (mortgage payments) and operating expenses into consideration.

Internal Rate of Return (IRR)

IRR is a more complex metric used to evaluate the potential profitability of an investment property over the entire holding period. It's particularly useful for comparing investments with different hold periods or cash flow patterns.

IRR takes into account:

1. Initial investment
2. Ongoing cash flows (rental income minus expenses)
3. Potential appreciation
4. Final sale proceeds

IRR is particularly valuable in real estate investing because:

1. It accounts for the time value of money
2. It considers both cash flow and appreciation
3. It allows for comparison between investments of different sizes and durations

IRR can be a useful tool in real estate investing, providing a single percentage that encapsulates an investment's potential return over its entire life cycle. However, it's most effective when used in conjunction with other metrics such as cash flow, cap rate, and cash-on-cash return.