What's Your REAL Cash on Cash Return?

Written by: Jason McMurtry, MBA

I was talking to a real estate investor the other day about potentially selling his rental property and the possibility of exchanging it for another, when he told me something unbelievable. By unbelievable, I mean I literally did not believe him. He said he wanted to sell the property but just couldn’t bring himself to do it because it was generating a 20% cash on cash return - from a single family rental property in Carlsbad, CA. He went on to tell me his tenants had been in place for about 10 years and he had done a great job maintaining the property and keeping rents at market rate. Beaming with pride Mr. Miller (name changed to protect the innocent) then explained to me that he purchased the property at a great price and had no debt so his cash flow was very high.

Not wanting to offend Mr. Miller but certain there was some sort of misunderstanding going on, I asked a few questions about the property and how his cash flow was being calculated. Were the property expenses being accurately deducted to calculate the net cash flow? Was there some sort of mistake in Mr. Miller’s math? Was this property a shortterm rental that only produced high cash flows some of the time, while generating zero cash flow at other times? I couldn’t find the disconnect, until Mr. Miller suddenly explained:

“I purchased the property thirty years ago for a hundred thousand dollars and now it’s generating twenty thousand dollars per year after expenses - a 20% cash on cash return! I have considered selling the property several times but I’ve never been able to find another investment with nearly as high a return.”

Now it all made sense. Mr. Miller was absolutely correct that netting twenty thousand dollars per year is equal to 20% of his original investment of $100,000 but absolutely wrong about receiving a 20% cash on cash return on his investment in this property.

When I asked Mr. Miller what the current value of his rental property was, he said he had received an offer not long ago for about one million dollars.

“Well, Mr. Miller, I have some good news and some bad news for you” I said. “The bad news is: you’re not getting a 20% cash on cash return; it’s actually more like a 2% return. The good news is, you may be able to increase your annual net cash flow by doing a tax-deferred 1031 exchange into a different property.”

The truth is, Mr. Miller was making a very common mistake amongst real estate investors.

The mistake is using the original purchase price, rather than the current equity value to calculate cash on cash return. This is a mistake because it fails to take into consideration the total equity being used to generate the return. This leads to errors when comparing current cash flow to the expected cash flow of a potential exchange property. In Mr. Miller’s case, he was losing out on potentially higher cash flows because he believed his property was producing a yield far higher than any similar alternatives.

To properly calculate cash on cash return, an investor starts by adding all rents and ancillary revenues from the property. The second step is to subtract property operating expenses. These include things like property taxes, insurance, mortgage, HOA dues, utilities, repairs & maintenance, and other expenses. When forecasting future cash on cash returns, it is also important to budget for unanticipated repairs, vacancy, and turn over expenses. Once all the expenses have been calculated, they are subtracted from the gross rents to arrive at the net rent amount. This annualized number is then divided by the equity value of the property to arrive at cash on cash return. See the example below:

Having a clear understanding of how to calculate cash on cash return is important. Making this calculation should be one of the first steps an investor takes when beginning the process of evaluating alternative options. By clearly understanding the financial performance of their current investment, an owner can get a good sense of whether or not there is room for improved performance (higher rents) or if other properties may be a relatively attractive option.

Once Mr. Miller realized his actual cash on cash return was a mere 2%, he was better prepared to compare alternative properties and evaluate them fairly, and therefore better able to make a financial decision that was in his best interest.

Jason McMurty is the founder and managing partner of 1031 Capital Solutions® an investment firm specializing in securitized, fractional interest 1031 exchange investments for real estate investors. He is also a Realtor® with Coastal Pacific Real Estate in La Jolla, CA. #01781509

1031 Capital Solutions is a branch office of DFPG Investments, LLC. Securities and Advisory Services offered through DFPG Investments, LLC, Member FINRA/SiPC The contents herein constitute neither an offer to sell nor a solicitation of an offer to buy any security, which can only be made by prospectus. Investors should understand all fees associated with a particular investment and how those fees could affect the overall performance of the investment. Neither 1031 Capital Solutions or its representatives, nor DFPG Investments, LLC provide tax or legal advice, as such advice can only be provided by a qualified tax or legal professional, who all investors should consult prior to making any investment decision. Past performance is no guarantee of future results.SDIAA