Proper Investing

Cash-on-Cash Return: Beyond Pro Formas & Cap Rates

The adversity most investors in commercial real estate are going through right now is leading to a new industry paradigm when it comes to analyzing investment properties. Not only are investors themselves looking for new, more practical ways to analyze these properties, underwriters are as well.

Cash flow is king!

To make successful deals in today’s market, capitalization rates and pro forma numbers take a back seat to cash-on-cash returns and accurate pricing. Financing is the biggest stumbling block in the market today. Capital is scarce, scared or patient. As a result, property owners who used to quote cap rates are now paying much more attention to cash flows. Cash flow is king! Equity and appreciation are secondary at best.

The questions for distressed property investors are whether the property has positive cash flows and the prospects of maintaining current tenancy levels. Prospective buyers and sellers are also paying more attention to the quality of the tenants than they were 18 months ago. Back then, vacancies were viewed as opportunities by the landlord to add value. Now they are a major liability.

Cap rates can only tell you so much about a property. For example, let’s say you have two retail properties with the same cap rate. One is a NNN, single-tenant space with a creditworthy lessee and a long-term lease in place. The other contains three tenants, one or more of which may be of questionable creditworthiness with shorter-term leases in place. All things being equal, it wouldn’t take a rocket scientist to figure out which of these is the better investment in today’s market. That’s why investors, like banks, are looking more and more at cash-on-cash return.

Cash-on cash is the ratio of annual before-tax cash flow to the total amount of cash invested, expressed
as a percentage.

                                         Annual Before-Tax Cash Flow
Cash-On-Cash Return = -----------------------------------------
                                               Total Cash Invested

For example, 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 x 12 = $60,000, so the cash-on-cash return would be 20% ($60,000 / $300,000 = .20).

However, it’s important to note that although cash-on-cash return is a better determinant of cash flow than cap rates are, it is still not perfect and should be used as just one tool in an arsenal for analyzing investment  properties. Because this calculation is based solely on before tax cash flow relative to the amount of cash invested, it cannot take into account an investor’s tax situation, the particulars of which may influence the desirability of an investment.

Washington DC Commercial Real Estate Insight.