Investors often speak about “cash on cash” return, particularly in real estate. In this article, we explore what “cash on cash” means and how to calculate it.
In its simplest form, cash on cash refers to the cash flow an investor receives as a percentage of the cash equity that an investor has put into a project (or company). For example, if an investor puts $1mm of cash equity into an office building investment and earns $100,000 in cash flow, then, the investor has earned a 10% cash on cash return.
Cash on cash return = Cash Flow Post Debt Service / Equity Invested
Cash on cash is a favored return metric of many investors, particularly in real estate, because it is uninfluenced by accounting treatments or non-cash adjustments. It answers the very simple question of: how much cash will I receive as a percent of how much cash I’ve put into the deal?
Cash on cash returns differ than levered equity returns that are referenced by public equity investors due to the different treatment of principal paydown. With cash on cash returns, an investor is interested to know what their return is after making interest and principal payments. However, public equity investors measure cash flow based on interest payments only and generally exclude principal payments.
The reason real estate investors look at cash on cash vs. public equity investors who look at levered equity yields is partially due to historic conventions (the “this is just how people look at it” argument) and partially due to the loan types available to real estate investors vs. public equity investors. Real estate investors often take out mortgages that amortize over a specific period of time, which means that their monthly debt payments include both interest and a portion of the principal balance.
On the other hand, public companies very often take on debt that only requires interest payments during the life of the loan and then a full payment of the principal at loan maturity, which is referred to as a balloon payment. Public companies will often look to refinance their debt prior to maturity to avoid having to make a large balloon payment, which means that as long as debt markets are favorable, a public company with good credit can avoid making principal payments for many years.
The Factors that Influence Cash on Cash Return
Cash on cash returns are influenced by many of the same factors that affect other valuation multiples including growth rates and perceived risk. Additionally, the amount of financial leverage (debt) employed in the business is a large determining factor in the level of cash on cash return. Before discussing leverage, let’s discuss some of the intrinsic factors that drive cash on cash returns:
Growth rates – assets or businesses with high forecasted growth rates will often yield lower cash on cash returns in the initial years of the investment since investors expect the cash on cash returns to improve in the mid to long-term. For example, let’s assume that Asset A has 0% growth rate in cash flow and Asset B has 10% growth rate in cash flow. Since the cash on cash returns of Asset A will be the same over time, an investor will demand a cash on cash return that is compelling from day one. Let’s assume the year 1 cash on cash return for Asset A is 12%. Since Asset B will grow cash flow over time, an investor may be willing to accept a lower cash on cash return in year 1 since the investor expects cash on cash return to improve in the future.If this investor accepts a 10% cash on cash return in year 1, then, by year 3, the investor will receive a 12.1% cash on cash return. By year 4, the investor will receive a 13.3% cash on cash return. Since the cash flow grows every year, the cash on cash return that the investor receives improves every year.
Risk – investors will demand higher cash on cash returns for investments that have higher perceived risk. This risk can come in many different flavors. For example, investors in an office building in a suburban market with modest corporate demand drivers will likely demand a higher cash on cash return than an office building in a dense urban market like New York. The depth of demand drivers in an urban market creates less risk for the investor, and as such, an investor is likely willing to accept a lower cash on cash return for this type of investment.Asset quality can also affect the risk profile of a real estate asset. Newly constructed assets are generally viewed as carrying less risk than a building that is fifty years old which may have more unpredictable capex requirements. Competition can be a big factor affecting risk. If competitive intensity has been increasing, an investor will demand higher cash on cash returns to compensate for the higher risk.
Financial leverage – the amount of debt that an investor takes on as part of an investment has a dramatic impact on the level of cash on cash return that is achievable since borrowing money reduces the amount of equity that an investor must put in. We will look at this in more detail in the next section.
The impact of financial leverage on cash on cash returns
Borrowing money to make an investment can dramatically increase an investor’s cash on cash return if the investor can borrow at a rate that is less than the unleveraged return of the asset.
In real estate terms, the unleveraged return of the asset is the cap rate, which is equal to net operating income (NOI) divided by the value of the property. Please refer to our article on cap rates for a cap rate refresher.
For example, let’s assume an investor purchases an office building for $10,000,000, and this building generates $1,000,000 of cash flow before any debt payments (the NOI of the property). The cap rate for this office building is 10%. Now, let’s look at a few leverage scenarios and see how it impacts our starting point of 10% cash on cash return.
Scenario 1 – Investor takes out an interest only loan at 8% interest and at 65% loan to value
Loan amount = $6,500,000
Equity required = $3,500,000
Yearly interest expense = $520,000
Cash flow post debt service = $480,000
Cash on cash return = $480,000 / $3,500,000 = 13.7%
Scenario 2 – Investor takes out an interest only loan at 8% interest and at 90% loan to value
Loan amount = $9,000,000
Equity required = $1,000,000
Yearly interest expense = $720,000
Cash flow post debt service = $280,000
Cash on cash return = $280,000 / $1,000,000 = 28%
*Notice how taking up the loan to value to 90% dramatically increases the cash on cash return to 28%. However, the risk profile of this investment has greatly increased since this investor has little margin of safety if the property does not perform well. If there is a sudden drop in cash flow, this investor will have trouble making debt payments faster than the investor who has borrowed at 65% loan to value.
Scenario 3 – Investor takes out an amortizing loan at 8% interest, 65% loan to value, and 30-year amortization period
Loan amount = $6,500,000
Equity required = $3,500,000
Yearly debt service (interest expense and principal paydown) = $572,336*
Cash flow post debt service = $427,664
Cash on cash return = $427,664 / $3,500,000 = 12.22%
*This $572,336 debt service was calculated in Excel. At a high level, this payment will include interest expense at 8% and a partial paydown of the principal balance such that the entire balance would be paid off after 30 years.
You will notice that an amortizing loan creates a lower cash on cash return for the investor than an interest only loan due to the higher debt service associated with principal paydown. In theory, the investor is benefiting from an increased equity value due to the decreased loan balance, but the strict cash on cash return calculation is reduced by the amount of principal paydown.