This is the third of three formulas for buying rental property.  In this article I will compare the cash-on-cash returns for the rental purchases described in the previous two articles.

Buying a Rental:  Loan Formula

Buying a Rental:  Cash Formula

The cash-on-cash return is the ratio of annual before-tax cash flow to the total amount of cash invested, expressed as a percentage.

CASH-ON-CASH RETURN =    ANNUAL BEFORE-TAX CASH FLOW / TOTAL CASH INVESTMENT

Example 1:  BUY A RENTAL WITH LOAN FORMULA

Suppose you purchase a $150,000 rental with a $30,000 down payment and $20,000 in closing, finance, holding, and fix-up costs for a total cash investment of $50,000.  You finance the balance of $120,000 for 4% APR on a 30 year fixed rate loan.  Each month, the cash flow from your rental, less expenses, is $427.  Over the course of a year, the before-tax income would be $427 × 12 = $5,124 so the cash-on-cash return would be

$5124

_______   =  .10248  = 10.25%

$50,000

Example 2:  BUY A RENTAL WITH CASH FORMULA

Suppose you purchase a $150,000 rental with a $150,000 cash and $16,000 in closing, holding, and fix-up costs for a total cash investment of $166,000.  Each month, the cash flow from your rental, less expenses, is $1,000. Over the course of a year, the before-tax income would be $1,000 × 12 = $12,000 so the cash-on-cash return would be

$12,000

_______   =  .072289156  = 7.23%

$166,000

CONCLUSIONS:

You will get a higher rate of cash-on-cash return (10.25%) by financing 80% of the purchase at 4% APR.

You will get a lower rate of cash-on-cash return (7.23%) by paying cash for the property.

You will get a higher monthly income if you pay cash.

*LIMITATIONS TO CASH-ON-CASH CALCULATIONS:

• Because the calculation is based  on before-tax cash flow relative to the amount of cash invested, it cannot take into account an individual investor’s tax situation, the particulars of which may influence the desirability of the investment.
• The formula does not take into account any appreciation or depreciation.
• It does not account for other risks associated with the underlying property.
• It is essentially a simple interest calculation, and ignores the effect of compounding interest. The implication for investors is that an investment with a lower nominal rate of compound interest may be superior, in the long run, to an investment with a higher cash-on-cash return.

It is possible to perform an after-tax Cash on Cash calculation, but accurate depictions of your adjusted taxable income are needed to correctly address how much tax payment is being saved through depreciation and other losses.  It is always advisable to consult with your CPA or tax preparer before buying real property for investments purposes.

*Most of the text for this “Limitations” section and certain phrases used earlier were adapted from the Wikipedia article titled Cash on Cash Return.