We’ll define cash-on-cash (COC) return, as well as explain what it means for you as an investor, especially as distinct from the more common “rate of return” and IRR metrics. Popular with mindful investors because it deals with the here and now of how an investment is likely to perform out of the gate, as well as what it is likely to yield, regardless of when and whether the investment is sold and for what cap rate.

What is cash-on-cash return in investing?

This fundamental concept in the world of income investing is different from IRR. COC return measures the annual cash distributed to you as an investor, divided by the total cash invested. It provides a clear picture of how much money an investor can expect to receive each year based on their initial cash investment.

Formula: COC Return = Cash Distributions / Total Cash Invested

Examples:

• Depreciation tax benefit? Not included.
• Pulled cash out in Year 2 because you refinanced the property? Yes, included.

The Concept of Cash-on-Cash Return

This metric focuses specifically on the cash flow generated from an investment in a particular year – excluding any tax impact – rather than the adjusted rate of return of the investment spread out over the lifetime of it. In other words, it’s used to help you figure out the level of income to expect from an investment.

For example, if an investor puts in $100,000 and receives an annual cash flow of $10,000, the cash-on-cash return would be 10%. $10k / $100k = 10%.

How Cash-on-Cash Return Differs from Other Returns

While there are various returns used to assess the profitability of an investment, cash-on-cash return differs in its specific focus on cash flow. Unlike other returns, such as Project IRR (Internal Rate of Return) or gross rental yield, cash-on-cash return takes into account the amount of cash invested rather than the total value of the investment.

IRR, for instance, tells you what the expected rate of return is over the life of an investment. On the other hand, gross rental yield measures the rental income generated by the property relative to its market value. These returns provide valuable insights, but they do not solely focus on the cash flow generated by the investment, especially in a particular year.

Calculating Cash-on-Cash Return

Now that we understand what cash-on-cash return is, let’s delve into how it is calculated.

1. Determine the net annual cash flow generated by the investment.
2. Divide the net annual cash flow by the total cash invested.
3. Multiply the result by 100 to express it as a percentage.

Calculating cash-on-cash return is an essential step in evaluating the profitability of an investment. By understanding the formula and applying it correctly, investors can gain valuable insights into the potential returns of their investment.

Example Calculation

Let’s consider a practical example to illustrate how cash-on-cash return is calculated. Suppose an investor purchases a rental property for $200,000 and expects to generate a net annual cash flow of $10,000. By applying the cash-on-cash return formula, we can calculate the return as follows:

1. Net Annual Cash Flow: $10,000
2. Total Cash Invested: $200,000
3. Cash-on-Cash Return: ($10,000 / $200,000) x 100 = 5%

Benchmarks: What’s a Good Return?

Many investors we speak with prefer to see a pro forma cash-on-cash return of at least 3-7% in Year 1 of an investment, and at least an 8% Preferred Return throughout an investment

When To Use COC Return vs IRR

Use Cash On Cash return when you’re investing for near-term income, rather than longer-term appreciation.

Think about a fund manager that boasts a track record of delivering 20% IRR to investors, net of fees, across its historical portfolio. Putting aside the fact that past performance doesn’t guarantee future results, this fund manager may specialize in buying properties in markets that appreciate over the long term (say, 7-12 years), while offering little if any cash flow in the meantime.

Does it fit your life and investment goals to sit around indefinitely, waiting and hoping that the fund manager delivers again on their historical track record, but not actually getting to experience liquidity or even income for your investment?

For many investors: yes, that’s fine. They’re focused on the long term, and they don’t need or want to touch that money until the investment is sold for a tidy profit. But for others, such as Lean FIRE investors? It wouldn’t work: the COC return in the early years of the investment wouldn’t be sufficient to pay for your expenses while you’re waiting for a sale of the property.

Some real estate syndications try to get around this by refinancing their investment in the early or middle part of the investment hold period. That really helps, as long as interest rates don’t rise much, and can deliver valuable cash back to the investor while keeping all of the initial investment in the deal.

Limitations and Risks of Relying on Cash-on-Cash Return

While COC return is a useful metric, it’s important to remember that it doe provide a limited perspective on an investment’s potential. This metric solely focuses on the cash flow generated from an investment and does not consider other crucial factors, such as taxes. Taxes can significantly impact the overall profitability of an investment, and failing to consider them may lead to inaccurate assessments of its true financial performance.

As we’ve touched on, another factor that cash-on-cash return overlooks is the potential for appreciation. Real estate investments, for example, often experience value appreciation over time, especially when combined with leverage, which can result in additional returns beyond the cash flow generated. Ignoring this aspect may lead to underestimating the long-term profitability of an investment, especially in growth markets such as the coasts and major cities.

Cash-on-Cash Return in Different Types of Investments

Cash-on-cash return can be applied to various types of investments, but let’s focus on its relevance in real estate and stock market investing.

Use in Real Estate Investing

In real estate investing, cash-on-cash return is a widely used metric for evaluating the profitability of rental properties. It helps investors determine the potential income generated from rental properties and assess their investment viability.

Use in Stock Market Investing

In the stock market, COC is not as commonly used as in real estate investing. However, it can still be a useful metric for investors looking to evaluate the income generated from dividend-paying stocks. By comparing the cash-on-cash return of different stocks, investors can identify those that yield higher income relative to the initial investment. Keep in mind, however, that you probably won’t be able to use leverage to increase COC return in this scenario, because the dividend yield of the vast majority of stocks will not outpace the margin loan percentage at which you can finance a stock purchase.

Overall, understanding COCR is essential for investors who are interested in income, particularly in the early years of an investment. Figuring out the Year 1 and Year 2 COC return of a 5-10 year investment can dramatically help with understanding how it will “feel” and what impact it will have on you in the near term, to make this investment.