What is the cash on cash return and how do you calculate it for a commercial property? Why is it important to evaluate the cash on cash return in commercial real estate transactions? Grueling questions, I know. Let’s dive in!
Cash on cash return is a simple measure of investment performance that is calculated as cash flow before taxes divided by the initial equity investment. The cash on cash return is the percent of annual before-tax cash flow to the total amount of money invested. It is often used to evaluate the cash flow from income-producing assets such as real estate. The cash flow before tax figure for each year is calculated on the real estate proforma, and the initial equity investment is simply the total purchase price less any loan proceeds.
Let’s take a look at the formula:
Cash On Cash Return = Annual before tax cash flow / Total Cash Invested
Now, Let’s look at an example... Let’s say you are considering purchasing a shopping center with leverage that cash flows $30,000 a year before taxes. Let’s also say that the final sale price of this property is $1,000,000 and you were able to secure a $750,000 loan to cover 75% loan to value. Thus your total cash invested is $250,000. The following calculation defines your cash on cash return:
12% = $30,000 / $250,000
Cash on Cash Return Considerations
Discounted Cash Flows
A discounted cash flow analysis uses concepts of the time value of money to value a commercial real estate asset. When looking at a time period extending out over a number of years, a DCF analysis estimates future cash flows and discounts cash flows back to the present. Using the discounted cash flow analysis will require forecasting future cash flows (incoming and outgoing), determining the necessary total return, and then discounting the forecasted cash flows back to the present at the necessary rate of return.
Internal Rate of Return
Internal rate of return (IRR) for an investment is the percentage rate earned on each dollar invested for each period it is invested. IRR is also another term people use for interest. Ultimately, IRR gives an investor the means to compare alternative investments based on their yield.
What is a good Cash on Cash Return in commercial real estate?
In short, a good cash on cash return is between 8% and 11%. However, there are many factors that should be evaluated in order to determine if the CCR indicates a good investment decision. Here a few factors to pay attention to.
If the maintenance on the property has been put off it will undoubtedly raise the CCR. Major repairs need to be considered in your own CCR evaluation.
Realize that the CCR does not account for the time value of money principle. A dollar today is more valuable than that same dollar would be in the future. Consider that the Cash on Cash Return will only be as strong as your assumptions.
Want to learn more about Dunhill investment principals? Contact one of our investment managers today!