Every investor knows the importance of having their money work for them.
But what if you could get $1 to do the same work as $5, $10, or even $20?
It can be done.
And there's an easy way to measure
how much heavy lifting
your money is doing for you.
And you can do this with a formula called
the cash on cash return.
Whenever you calculate cash on cash return,
it shows you how much money is being earned
based on the actual amount of cash
you have invested in the property.
In other words, it represents how hard your money is working for you.
It's ultimately a ratio of two numbers,
how much cash you have invested
versus the amount you've gotten back in earnings
in a given time period.
You can find your cash on cash return
by taking your annual pretax income
and dividing it by the actual cash you have invested into the deal.
And this gives you your cash on cash return.
Now it's important to recognize
we're not dividing it by the total cost of the asset.
We're dividing it by the amount of cash you have put into it.
For example, if you buy a rental property for $100,000
but you only put down $20,000 of your own cash to buy and improve it,
and then your net gain for the year.
In other words, the money you actually put into your pocket
after all expenses and debt service are paid is $5,000
then your cash on cash return is calculated
by taking $5,000 and dividing that by the $20,000, you have invested
giving you an annual cash on cash return of 25%.
Easy enough. Right?
And did you notice how the full purchase price
of $100,000 wasn't even included in that calculation?
That full purchase price didn't play any part
in figuring out what your cash on cash return was.
What if you put down $10,000
while earning that same amount of net income?
Well, then your cash on cash return would be 50%.
What if you only put down 3.5%?
Well, then your cash on cash return would be $142.86%.
I mean, heck what if you could put nothing down?
Well, in that case, your cash on cash return would be infinite.
It literally couldn't get any better.
And as you crunch these numbers,
it might even make you start to wonder
how could I invest as little as possible in any deal I pursue
to make my cash on cash return better and better
and make my money work harder and harder for me?
Now unfortunately, the cash on cash return can be a little misleading,
even though it's a simple formula with only two basic numbers at work,
some investors can pretty easily miscalculate
one or both of these numbers.
Either the annual net income
or the initial cash investment.
When these numbers are miscalculated,
what looks like a 10% cash on cash return when you buy
could easily turn into a 10% loss,
if you start renovating
or discover the renovation costs are
twice as much as what you estimated.
Things can also go sideways if the property sells for than you expected
or generates significantly less revenue than you anticipated,
or if the vacancy rate proves to be a lot higher than you thought it would be,
or any number of other unexpected problems.
So, while the math is easy,
using accurate numbers can often be kind of a challenge.
The cash on cash return makes use
of one of the greatest advantages
real estate has over other types of investments.
And that is leverage.
The ability to buy assets that are worth
far more than you could buy on your own
because you're able to invest with borrowed money.
Now, the other side of the coin to using other people's money is
that when you borrow money,
every extra dollar you borrow means higher interest fees
and ongoing debt service payments.
Consider a rental property for example,
let's say you buy a rental property for $100,000 cash
and rent it out for $1,200 a month.
Let's assume your non mortgage expense
comes out to $500 per month or $6,000 each year,
including everything from the vacancy rate
to property management fees,
to taxes, repairs, and insurance,
which leaves you with a net income of $700 per month.
Now since you bought it with $100,000 cash
with no financing at all,
your annual net revenue comes up to $8,400.
That means you have a cash on cash return of 8.4%.
Now for a rental property
or an investment that generates
this kind of return year after year
that's a pretty solid return
that most investors would embrace.
Now, imagine you finance the purchase of this property instead
borrowing $80,000 at 6% interest for a 30-year loan.
And instead of coming up with $100,000 of your own cash,
you only invest $20,000,
but now you're also settled
with an additional monthly expense
of $479.64 for the mortgage payment.
Well, that brings your monthly cash flow down to only $220.36
putting your annual profit at $2,644.32.
So while this drastically reduces
your annual net income from the property,
it also drastically improves your cash on cash return,
bringing it up to 13.22%.
So even though your annual return is much lower,
your smaller $20,000 cash investment
is still working much harder
than if you would purchase this property
without any financing at all.
And if you took the same $100,000 cash amount you had in the first place,
you could potentially buy five properties like this
and ultimately make a lot more money in the long run
and have a much stronger
cash on cash return for each individual property.
So, cash on cash return is a simple and effective way
to analyze and compare any investment,
whether it's real estate or otherwise.
But like any ratio, it doesn't give you enough information
to make a fully informed investment decision.
So, don't stop here.
It's just one of several tools you can use
to predict what the outcome will be.
Take the time to analyze a deal with several different formulas,
to get a deeper understanding of the upsides and downsides
to the opportunity you're looking at.
If you want to learn about another common formula,
be sure to check out this other video
to learn about cap rates
and the important role they have to play
in evaluating an investment property.
Thanks a lot for watching.
I hope you enjoyed this video
and if you want to expand your real estate knowledge even further,
be sure to check out retipster.com
and head over to the Terms Library,
where you can learn about all kinds of formulas, tricks
and other investment terminology
that you're going to need to know
in the real estate industry.
See you next time.