Before you can analyze the merits of a for-sale listing you need to have a basic understanding of the property’s numbers. By that I mean you need to thoroughly understand:
- How a property is valued
- How a loan amount is calculated
- How a property’s cash-on-cash return is calculated
- How loan amortization impacts a property’s cash-on-cash return
- How leverage (the amount of debt borrowed to purchase the property) affects a property’s cash-on-cash return
“In your sleep”
You not only need to know the importance of these numbers, but you need to know how to do these calculations “in your sleep.” They need to become second nature to you.
In the first part of this five part series we discussed how a property is valued. In the second part of the series we discussed how the loan amount is calculated. The first two CRE metrics admittedly were very basic but absolutely necessary for a foundational understanding of CRE underwriting. Today, we will discuss how to calculate a property’s cash-on-cash return.
CRE Metric #3 – How a Property’s Cash-on-Cash Return Is Calculated
What is the most important metric to use in deciding whether or not to purchase a property? I suppose this question is open for debate but for me it’s not. Assuming the perceived risk between investment alternatives is more or less the same, then in my opinion, the most important metric for purchasing a property is its cash-on-cash return. There are many other metrics that are also worth considering but they are secondary to a property’s cash-on-cash return.
Assume the following underwriting parameters:
- $1,000,000 purchase price
- $684,000 loan amount
- $60,000 NOI
- $4,000 per month mortgage payment
So let’s do the math. The cash flow after debt service (CFADS) is:
$60,000 NOI – ($4,000 per month DS x 12 months) = $12,000 CFADS annually
The total cash invested in this property is the purchase price less the loan amount or $1,000,000 – $684,000 = $316,000 total cash invested (TCI)
Therefore, the cash-on-cash return (COCR) is:
$12,000 CFADS ÷ $316,000 TCI = 3.8% COCR
Is the projected COCR acceptable?
So the first question to ask yourself, “Is the projected COCR acceptable?” It depends. If you live in New York City or most places in California, a COCR in this range would be unheard of. Investors in these two locations rely almost solely on appreciation to justify buying a rental property. Now if you lived in the Midwest, it’s not uncommon for investors to experience COCRs at or near double digits. So why aren’t we all buying real estate in the Midwest? Because property appreciation in this region, the second benefit of owning real estate, is generally modest at best, counterbalancing the excellent COCRs.
So again, it all depends. For me, a 3.8% COCR is borderline. As a rule of thumb, a property needs to project a COCR of 4% or greater before I would make an offer. However, there is one very important exception: If the property shows significant upside potential in the first couple of years then I very well could consider a modest 3.8% cash-on-cash return acceptable in the first year of operation. Other seasoned real estate investors may think otherwise, and I wouldn’t feel the need to argue with them. It’s all a personal choice.
Our buyer decides to buy the property at the asking price of $1,000,000 because he believes the property is being poorly managed. With a new on-site manager reporting directly to him he strongly believes the property’s NOI in the first year will increase by $6,000 to $66,000. Assuming that is true the property’s cash flow after debt service increases to:
$66,000 NOI – ($4,000 per month DS x 12 months) = $18,000 CFADS annually
And the property’s cash-on-cash return is now:
$18,000 CFADS ÷ $316,000 TCI = 5.7% COCR
That in my opinion is a very acceptable first year return on the buyer’s equity.
Two ways to calculate COCR
Before we move on to the next topic, I need to explain something that I glossed over. Did you catch it? When I calculated the total cash invested (TCI) I subtracted the loan amount from the purchase price. In this example the total cash invested in this property was $316,000 ($1,000,000 – $684,000). But is that true? No, not really. What about the closing costs? What about the loan or mortgage broker fee, pro rata share of the property taxes and the title and escrow charges just to name some of the more significant closing costs? These costs are not small and together they make a tidy sum. So in reality the total cash invested is:
Purchase Price – Loan Amount + Closing Costs = Total Cash Invested
Let’s assume that closing costs total $20,000. Then the total cash invested is $336,000, not $316,000. And how would that affect COCR?
$18,000 CFADS ÷ $336,000 TCI = 5.4% COCR compared to 5.7% without the closing costs included
So adding in the closings costs to the TCI does have a small effect on the property’s COCR. So why didn’t I include closing costs in the total cash invested? Was it because I’m lazy or that it’s not important? No, not at all. There is a reason for my excluding the closing cost, which is a very important concept to understand
Return on Investment vs Return on Equity – Which is Better?
A real estate investor can choose to focus on a property’s Return on Investment or they can focus on property’s Return on Equity. So how are these two metrics calculated? And more importantly, how are they different?
Return on Investment (ROI) measures the gain or loss generated on an investment relative to the amount of money originally invested, including closing costs.
Return on Equity (ROE) measures the gain or loss generated on an investment relative to the amount of equity in the property.
So the first time we calculated the property’s COCR we were calculating ROE. The second time we calculated the property’s COCR we were calculating ROI.
My preference between the two metrics is Return on Equity. Why? My answer is easier to understand by looking at the property’s return several years in the future. So let’s assume the value of this property seven years from now is $1,900,000 and that the property’s NOI at that time is $100,000. In seven years the loan has been amortized down to $568,762 from the original loan balance of $684,000. What is the property’s COCR, based on ROI and ROE?
Let’s begin by re-calculating the property’s cash flow after debt service
$100,000 NOI – $48,000 DS = $52,000 CFADS a.k.a. Owner Distributions
Now let’s calculate ROI and ROE.
Return on Investment (ROI)
$52,000 CFADS ÷ $336,000 TCI = 15.5%
Return on Equity (ROE)
$52,000 CFADS ÷ $1,331,238 Owner’s Equity ($1,900,000 Value – $568,762 Existing Loan Balance) = 3.9%
The property’s ROI is 15.5%. What does that mean? It means the return the buyer is now receiving on his original investment of $336,000 is a healthy 15.5%. That’s a very good return, but it’s also misleading and here’s why. On the face of it, a 15.5% return means you should be very happy with your investment. Right? Who wouldn’t be happy with a 15.5% return? So the happy investor would be prudent to leave this property alone and let it continue as is. Correct? Hold on. Not so fast.
Now let’s analyze the property’s ROE of 3.9%. What does that mean? It means the owner is receiving a below average 3.9% return on the equity he currently has in the property. The question this mediocre return begs to ask is this: Should I consider either refinancing this property or selling this property sometime soon? The answer is yes.
Why ROE is better than ROI
For me, when the ROE dips below 4% I need to take some action to boost the property’s return. Does that make sense? But if you are measuring a property’s success based on ROI, you’ll never see the need to take action. Why? Because the property’s ROI will continue to improve as the property’s NOI increases over time while the amount of the original investment stays the same. So instead of a 15.5% ROI, over time this property’s ROI will increase to 18%, 20% or more while the ROE continues to decline.
To illustrate my point, shown below is a hypothetical projection of the property’s NOI and property value.
Notice that the property’s ROI continues to increase over time. And notice the property’s ROE peaked in Year 4 and then slowly declines thereafter. In Year 7 the property’s lower ROE suggests some action needs to be taken to improve its return.
This may suggest that the property should be refinanced. When a property is refinanced the owner re-leverages the property with more debt. It benefits the owner two ways: 1) he gets cash back from the refinance that he uses as he chooses; and 2) a re-leveraged property in most instances will improve a property’s ROE. Sometimes the owner realizes that the best course of action is to sell the property and if the proceeds of the sale are re-invested in another rental property, then that too will likely result in a better ROE than the status quo.
And that is why I prefer using ROE over ROI. Over time, ROE has the potential of helping the owner make informed decisions about what should be done to maximize the property’s return. ROI does not.
Notice that over the 10-year projection the property’s ROE averages about 4%. And yet the owner’s equity in the property increased over this same time period by almost $1.3 million. Even with a modest ROE the investor’s equity in his property increased 5 times over the holding period. Wow! Not too shabby! During times of rising property values, a property’s ROE may still be modest as is shown in this example but result in exceptional equity grow.
Another Advantage of ROE vs ROI
One final thought about the chart above. In this example the property’s capitalization rate has compressed over the ten-year projection from 6.0 percent in year 0 to 5.25 percent in year 10. This is exactly what has happened to real estate since the Great Recession. Cap rates have slowly but steadily compressed since 2009. If the property had maintained a 6 percent cap rate over this time period the property would only be valued at $1,821,000 in year 10, not $2,081,000 as shown in the chart above and the property’s ROE would have improved to 4.7%, not 3.9%.
The point I’m trying to make is this: Regularly monitor your property’s ROE to determine if there is a trend in this important ratio. If so, it may be suggesting you need to take action to maintain an acceptable ROE for your property.
Doug Marshall, CCIM is the award winning author of Mastering the Art of Commercial Real Estate Investing. Check it out at Powell’s.