Tuesday, December 12, 2006

'Cash On Cash' Definition Comes Up Again

Questions about "Cash On Cash" (the name of this column, and what it means) came up in two emails this week. I'll explain again, for while its not complicated, its not something most people deal with every day. I do, though! ;)

In investing, 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. It is often used to evaluate the cash flow from income-producing assets. Generally considered a quick napkin test to determine if the property qualifies for further review and analysis. Cash on Cash analyses are generally used by investors looking for properties where cash flow is king. We in the business, however, also use it to determine if a property is underpriced, indicating instant equity in a property.

Suppose an investor purchases a $1,200,000 apartment complex with a $300,000 down payment. Each month, the cash flow from rentals, less expenses, is $5,000. Over the course of a year, the before-tax income would be $5,000 × 12 (months) = $60,000. You then divide your before-tax income ($60,000) by the down payment invested, or initial equity ($300,000). So the cash-on-cash return would be .20, or 20 percent.

Because the calculation is based solely 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.

I need to point out that this calculation does not take into account appreciation of the property, nor depreciation (cost recovery), which provide additional value when calculating a project's worth.

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