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ALL ABOUT REAL ESTATE INVESTMENT STRATEGIES
Understanding "Cash on Cash" return The overall goal of a real estate investor should be to minimize risk and maximize wealth. Too often however, methods of evaluating a real estate investments fall short of the mark by failing to deal in-depth with risk or the potential for wealth accumulation. A popular measure of return with some real estate investors is the "cash on cash" method of evaluating income producing property. In order to calculate your return on investment in an income producing property it is critical to accurately determine the cash flows. While real estate investments should be calculated on an after tax basis, we're going to take a look below at the way the 'Cash on Cash Return' short cut is often calculated. Continued below
Cash on cash return is determined by dividing before-tax cash flow by the total cash invested in the property. Before-tax cash flow is income less operating expenses, less debt service (mortgage payments.) Total cash invested would include the down payment and all nonrecurring costs, such as loan fees, attorney's fees, title insurance, survey, environmental inspections, etc. Recurring costs, such as insurance premiums paid in advance, property taxes, and utility adjustments, should not be included in total cash invested. An investment property with a before tax cash flow of $5,500 and a total cash invested of $50,000 would have a cash on cash return of 11%. Example Gross rental income 26,300.00 Less vacancy allowance 1,300.00 Gross operating income 25,000.00 Less operating expenses 9,500.00 Net operating income 15,500.00 Less debt service 10,000.00 Cash flow before taxes 5,500.00 Cash on cash return is easy to calculate, but it can be misleading. While in the eyes of some investors, it may be a reasonable starting point to evaluate a project, it is simply not enough to justify a decision, and may cause an investor to choose an unrealistic investment project. Surprisingly though, some investor's continue to be influenced by the cash on cash method of evaluating a real estate investment. There are many things that must be considered when evaluating an income property. The cash flows will not be constant over the life (holding period) of the project. While vacancies can rise and operating expenses can increase, the cash on cash method deals only with the before tax cash flow in the first year of the investment. An in-depth "investment value" analysis should be performed on an after tax basis, capitalizing on every opportunity for financial structuring and tax planning. An investment value analysis calculates annual cash flows throughout the life (projected holding period) of the project. It also considers the "time value of money", that is, it reflects the fact that early dollars are more valuable than later dollars in the future year cash flows. Future year after tax cash flows are discounted back to a Net Present Value (NPV) arriving at an investment value, the price an investor can afford to pay for a property that will support their after tax return objectives. Take control of your potential for creating great wealth in your real estate portfolio. If you're not evaluating your real estate investments in-depth, there is little doubt you're cheating yourself. If the person you're relying on for real estate investment leadership isn't qualified to analyze in-depth on an after tax basis, you need to find someone who is. Seek the counsel of a CCIM, a certified specialist in commercial investment real estate. About the
author: Stewart L. Mac Donald, CCIM, is
President of Real Estate Assets, Inc., a consulting
services company focused on maximizing wealth through Asset
Management in the real estate portfolio. Mr. Mac
Donald has counseled on and has been an active participant in a
wide range of investment real estate projects. He has written
and presented seminars on "Strategic Planning in the
Investment Real Estate Portfolio" before bar associations,
financial planning and investment groups.
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