Every investment is only as much worth as the return it generates for you. In every business, you have to evaluate profitability, if you want to have any hopes of staying afloat. More importantly, you need to calculate the cash inflow for every investment you make. When it comes to real estate investment, one way of knowing the profit generated from a venture is to calculate the cash on cash return percentage.
Of all the investments you will make in your lifetime, the most important is real estate. If you have bought a property, not as a home, but as a pure financial investment, you need to evaluate the cash return that it is generating for you.
Cash on cash return is the ratio of the profit or cash flow generated by a property and the amount of net investment made in it, multiplied by 100. The cash flow or profit generated, which is used in its calculation, does not include taxes charged on the returns. That is, the profit considered is before taxes. Thus, it is the percentage of cash that is recovered from your initial investment in a property.
This calculated ratio is mostly considered only a year after the purchase of a property. That is, it is only an estimate of the fresh profit generated, after a year of property purchase. It is not an accurate estimate for later years, as it doesn’t take the time factor into consideration.
Most importantly, this ratio doesn’t consider the appreciation in price of property that may happen with time. Even though a property might be generating meager cash flow, its inherent worth might have increased with time. This ratio does not take this fact into consideration. That’s why, it is not the ultimate indicator of the profitability of any property investment. It can only provide you with an idea about the profit you are making through rental properties, or from any other business related to it.
Let me present you with the associated calculation formula. The above definition itself, must have made it quite clear. The formula is as follows:
Cash on Cash Return = [Net Cash Inflow (Before Taxes)/Total Cash Investment] x 100
So, if one has made a USD 160,000 investment in a property and receives a USD 20,000 cash return in one year, the percentage would be:
Cash on Cash Return = (USD 20,000/USD 160,000) x 100 = 12.5%
Thus, calculating the return ratio can provide you with an idea about the profitability of your real estate investments. The higher the return ratio, faster you will recover your initial investment in a property. Properties with a low ratio are a liability, unless their value is progressively increasing in the property market. A periodic evaluation of your investment returns is essential. Hope this article has clarified your understanding of this financial concept, which is applied in real estate investment evaluation.