Simply put, cash-on-cash yield measures the annual return an investor earns on real estate compared to the amount of mortgage paid in the same year.
The return depends on a few variables - investors, local markets, and your expectations for future value growth. Some real estate and property investors are happy with a safe and predictable set of cash-on-cash returns of 7% to 10%, while others have a cash-on-cash return of at least 15%.
Cash-On-Cash Return = (Annual cash flow before taxes) / (Total cash invested)
However, investors should always be aware of the tax treatment of their investments. High taxes can wipe out potential investment returns if cash-on-cash returns are low.
Suppose ABC Company decides to buy commercial space for $1 million. The company pays a down payment of $200,000 and borrows an $800,000 mortgage at the bank. In addition to the deposit, the company has to pay various fees of $20,000. ABC Co leases commercial space to multiple companies.
After a year, the annual rental income from the property is $120,000.
In addition, mortgage payments, including principal and interest payments, are $30,000. To calculate cash-on-cash returns, you must first determine the annual cash flow from your investment.
The annual cash flows for the first year of ABC Co are as follows:
Annual Cash Flow = Annual Rent - Mortgage Payment or...
Annual Cash Flow = $120,000- $30,000 = $90,000
Next, you need to find the total amount of cash invested. This is the amount the company has spent investing without leverage.
The total investment is calculated as follows:
Total Investment = Deposit + Fee
Total Investment = $200,000 + $20,000 = $220,000
You can use the above information to determine your cash-on-cash return for the first year:
Cash on Cash Return for ABC Co = $90,000 / $220,000 = 0.41 or 41%
Since the calculation is based only on pre-tax cash flows related to the cash invested, it cannot take into account the tax situation of individual investors.
However, investors can usually deduct enough capital cost reserves to defer taxes for an extended period of time.
Cash-on-cash return is essentially a simple interest calculation, ignoring the effects of compound interest.
What it means for investors is that an investment with a low nominal compound interest may perform better than an investment with a high cash-on-cash return in the long run.
It is possible to perform an after-tax cash-on-cash calculation but to correctly show how much tax will be saved from depreciation and other losses, you need to represent your adjusted taxable income accurately.