There are many different ways to analyze investment property purchases. These financial ratios include: Cash on Cash Return, Cap Rate, Debt Coverage, Gross Multiplier, and Return on Asset to name a few. Which ratio you use depends upon your personal preferences as well as your financial goals, your risk tolerance, and even the type of property you are analyzing.
Cash on Cash Return is a good indicator if the property is a cash cow or is potentially under priced. Because most of the required numbers are readily available in the field, most investors will use this ratio as a quick test to determine if further analysis is required. Less seasoned investors may want to use a property spreadsheet or a an on-line property analysis tool to do the work for them.
The math equation is:
First, let’s calculate Annual Before-Tax Cash Flow:
- Calculate your yearly income from the property including rent and additional income such as laundry fees.
- Total all yearly expenses that you pay as the owner/landlord such as:
- Utilities (heat & electricity)
- Snow/Lawn Care
- Management/Care taking
- Subtract your yearly expenses from your yearly income to arrive at your Annual Net Operating Income.
- Calculate your mortgage payment using any on-line mortgage calculators. Multiply by 12 to get your annual mortgage payment.
- Subtract your annual mortgage payment and your annual tax amount from the above Annual Net Operating Income to arrive at your Net Annual Cash Flow. Make sure you did not include taxes more than once!
Your Total Cash Invested is quite easy. It is your down payment that you put in to acquire the property. You may be thinking, “what about closing costs”. Most investors will keep the process simplified by NOT including closing costs or other “acquisition costs”.
To calculate your Cash on Cash Return, simply divide Net Annual Cash Flow by Total Cash Invested. This will give you a percentage/ratio that you can use to compare investments. This number shows you how much of your cash out-of-pocket is returned to you each year by this investment. Because this is a quick test, it does not take into account any tax implications, depreciation, or appreciation.
Most real estate investors are looking for at least a 20+% Cash on Cash Return. Many will not even consider a property unless it generates a ratio of greater than 20%. I recommend that you run multiple examples to become familiar with this ratio before making a purchase decision using it.