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Real estate investing is an important wealth-building strategy to add to your arsenal, but it's important to understand the different metrics used to evaluate the potential returns of a investment property. One key metric that investors use to evaluate the profitability of a potential investment opportunity is the cash-on-cash (CoC) return. In this article, we'll explore what cash-on-cash return is, how to calculate it, how it compares to cap rate, and why it's an important metric for real estate investors.
Cash-on-cash return is a metric used to evaluate the cash flow of an investment property relative to the amount of cash invested in the property. In other words, it measures the annual return on investment based on the amount of cash the investor has put into the property.
For example, let's say an investor buys a rental property for $100,000 and puts $20,000 down (in cash). The investor collects $10,000 in rental income over the course of a year, and after expenses (mortgage payments, property taxes, repairs, etc.), the investor has $5,000 in cash flow. The cash-on-cash return would be calculated as follows:
Cash-on-Cash Return = Annual Cash Flow / Total Cash Invested
Cash-on-Cash Return = $5,000 / $20,000
Cash-on-Cash Return = 0.25 or 25%
In this example, the cash-on-cash return is 25%, meaning the investor is earning a 25% return on their cash investment in the property.
Another common metric used in real estate investing is the capitalization rate (or cap rate), which measures the rate of return on a property based on its net operating income (NOI) divided by its market value. While both metrics are used to evaluate the profitability of a property, they measure different things.
Cash-on-cash return measures the return on investment based on the amount of cash invested in the property, whereas cap rate measures the rate of return based on the market value of the property. In other words, cash-on-cash return is a more specific metric that focuses on the cash invested in the property, while cap rate is a more general metric that focuses on the overall value of the property.
While both metrics are important, they can be used in different ways. Cash-on-cash return is useful for evaluating the profitability of a property based on the investor's cash investment, while cap rate is useful for comparing the profitability of different properties based on their market value.
First and foremost, cash-on-cash return provides investors with a clear picture of the actual cash flow they can expect to receive from a property relative to the amount of cash they have invested in it. That's crucial for making informed investment decisions and evaluating the potential profitability of a property.
Additionally, cash-on-cash return can help investors compare the profitability of different properties with different financing structures. For example, if one property requires a larger down payment but generates a higher cash flow than another property with a smaller down payment, cash-on-cash return can help investors determine which property is the better investment.
Cash-on-cash return can also help investors evaluate the potential risks associated with a property. A high cash-on-cash return may indicate a low-risk investment, as the property is generating a significant amount of cash flow relative to the amount of cash invested in it. Conversely, a low cash-on-cash return may indicate a higher-risk investment, as the property may be generating less cash flow than expected or require a significant amount of cash investment to generate positive cash flow.
The definition of a "good" cash-on-cash return can vary depending on a number of factors, including the investor's personal goals, the local real estate market, and the financing structure of the investment property. As a general rule of thumb, however, many real estate investors aim for a cash-on-cash return of at least 8-12%.
A cash-on-cash return of 8-12% is considered a good target for many investors because it indicates that the property is generating a healthy amount of cash flow relative to the amount of cash invested in it. But it's important to note that this is just a general guideline and investors should evaluate the potential returns and risks of each investment property on a case-by-case basis.
In addition to cash-on-cash return, investors should also consider other factors such as potential appreciation, rental demand, and vacancy rates when evaluating the potential profitability of an investment property. It's important to have a comprehensive understanding of the local real estate market and to conduct thorough due diligence before making any investment decisions. And as always, the Picket platform is here to help you evaluate potential rental properties and connect with local agents who can help you get to know the local markets.
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