Cash on Cash Return on Investment - Explained
What is a Cash-on-Cash ROI?
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Table of ContentsWhat is a Cash-On-Cash Return on Investment?How is Cash-On-Cash ROI Used?The Calculation of Cash-On-Cash ReturnAcademic Research for Cash on Cash ROI
What is a Cash-On-Cash Return on Investment?
Cash-On-Cash Return is an indicator used in commercial real estate transactions to calculate the total return on money invested. It is one of the simplest profitability calculations to understand in the investment of real estate.
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How is Cash-On-Cash ROI Used?
Commercial real estate investors always use Cash-On-Cash Return to measure the effectiveness of investment. Also referred to as income from real estate investment, Cash-On-Cash Return offers business owners and investors projections in regard to transaction value as potential fund distribution over the period of investment. Cash-On-Cash Return is more applicable with investment properties that have long-term loans. When a real estate transaction involves debt, the actual ROI deviates from the standard return on investment. Standard ROI accounts for the total capital deployed into the investment including debt. Cash-On-Cash ROI, on the other hand, measures the returns made on personally-invested funds only and gives a more accurate analysis of investment effectiveness.
The Calculation of Cash-On-Cash Return
In a real estate phenomenon, the calculation of Cash-on-Cash Return is as follows: Imagine a real estate owner who invests in property land that does not generate any monthly income. The cost of purchasing the property is estimated to be $2 million. The investor decides to make a deposit of $200,000 and borrows another $1,800,000 from the bank. The investor then makes a payment of $20,000 from his own pocket to cater for the premiums and operating costs. After one year, the investor pays back $50,000 for the loan out of which $10,000 is considered the principal. One year later, the investor decides to sell the property at a rate of $2.2 million. This means that the investor has a total cash flow of $270,000. He receives $410,000 in cash after repaying a debt of $1,790,000. In this case, the return on investment is: ($41,000 - $270,000)/$270,000 = 51.9%. Apart from the generation of current income, cash payment can also be used to predict the expected investment cash flow. However, this is just a goal to evaluate the potential investment, but not a promising return. In conclusion, a cash payment refers to the estimated amount of cash that an investor can receive during the investment period.
Academic Research for Cash on Cash ROI
- Return Risk and Cash Flow Risk with Longterm Riskless Leases in Commercial Real Estate, Geltner, D. (1990). Real Estate Economics, 18(4), 377-402. This article discusses the risk characteristics of returns of a commercial real estate investment. It illustrates the correlation between propertys return risk and its cash flow. According to the authors, this correlation is important as it is reflecting the return risk that should matter most to the investor. The article further states that the propertys return risk is the market risk about which investors may have the most intuition and most objective information. This is associated with the fact that real estate assets are generally in securitized to observe the time series of returns that can help in the study of a returns risk characteristics.
- Sensitivity analysis, Rate, C., & Rate, S. R. (2005). This report proposes a sensitivity analysis of a real estate investment project. First, it explains the sample project by describing the space and location of the project. It then describes the cost and finance aspects of the project including the market financial details and projected capital plan. Further, quantifiable benefits of the project are described as well as an illustration risks and sensitivity associated with the project.
- Discounted cash flow: accounting for uncertainty, French, N., & Gabrielli, L. (2005). Journal of Property Investment & Finance, 23(1), 75-89. This article describes how business owners can account for uncertainty. According to the authors, the effect of introducing uncertainty in the input is to produce different answers. Using this technique is found to benefit the user who gets to understand the pros and cons of risks pertaining the single point estimate. It is revealed that the central tendency in uncertainty accounting is close to the single point estimate of the static model.
- Housing tenure choice, Mills, E. S. (1990). The Journal of Real Estate Finance and Economics, 3(4), 323-331. This journal discusses the concept of microeconomics in housing tenure. In an attempt to answer the question, how does a rational consumer make housing tenure decisions? the author bases his argument on an earlier paper in two ways. First, it integrates the concept of portfolio decision in a single, coherent analytical framework. It then presents a numerical analysis using specific national data and post-1986 tax provisions. The author concludes that the occupancy needed for a rational ownership is probably longer than it was during the 1970s and 1980s, and may even be longer than many economists suspect. Based on the numerical analyses, the author asserts that a larger US population should not be owner-occupiers regardless of the anticipated occupancy.
- Housing return and the determinants of the capitalization rate: with reference to Hong Kong, Tse, R. Y. (1996). Journal of Property Research, 13(2), 115-129. According to this paper, a property yield constitutes only a portion of the real estate rate of return. Other factors that influence return include the financial leverage effect of mortgage loans and house price appreciation. In equilibrium, the property yield is determined by the interest rate and house prices must grow concurrently with rents. According to the author, an equilibrium condition can enable generate a multi-period real estate return. The higher the expected return, the more attractive a real estate investment can be. In the case of Hong Kong, the author found that the real estate mean risk premium is 8% more than the prime rate. The higher the future capital appreciation, the lower the premium risk would be required, which results in lowering of the property yield.
- Real estate valuation: the effect of market and property cycles, Born, W., & Pyhrr, S. (1994). Journal of Real Estate Research, 9(4), 455-485. This paper describes the traditional real estate valuation model and how it impacts the real estate cash flow. According to the author, the model usually assumes a constant annual change in rent and expenses as well as constant terminal value capitalization rates for a period of 7 to 10 years. The author also uses a cycle valuation model to evaluate the correlation between real estate supply and demand cycles, equilibrium price cycles, rent rate catch-up cycles, inflation cycles, and property cycles. The results of the model are then compared to the traditional borrower and lender valuation model in order to produce a realistic present value estimate and valuation conclusions.
- Financing and Economics of Affordable Housing Development: Incentives and Disincentives to Private-Sector Participation, Black, J. (2012). This paper provides an overview of the Canadian affordable housing development and why there has been a decrease in such trend. It explores the concept of private-sector rental housing and why it has become unaffordable to the moderate income earners. In explaining the high costs of housing, the authors illustrate how the elimination of rental subsidies by the government has resulted in the inflation of housing rates. Further, the paper discusses the key players in the housing sector including the housing developers and providers.
- Agency costs of free cash flow, corporate finance, and takeovers, Jensen, M. C. (1986). The American economic review, 76(2), 323-329. This article explores the role of cash flow in corporate management using the agency theory. According to the author, payouts of cash to shareholders create major conflicts which have received very minimal attention. Payouts are found to reduce resources under the managers control, thus, affecting managers power. In an attempt to explain the conflict of interest, the author develops a theory that explains the benefits of debt in reducing agency costs of free cash flow, and how debt can be used to substitute free cash flow.
- Corporate cash reserves and acquisitions, Harford, J. (1999). The Journal of Finance, 54(6), 1969-1997. This article illustrates how cash-rich firms are more likely to attempt acquisitions. According to the author, stock return evidence indicates that acquisitions by such firms have decreasing value. Cash-rich bidders always destroy the value of the bids by 7% for every excess dollar the reserves hold. Consistent with evidence of stock return, the author asserts that mergers which involve cash-rich bidders are always followed by decline in the operating performance.
- Developing ratios for effective cash flow statement analysis, Carslaw, C. A., & Mills, J. R. (1991). Journal of Accountancy, 172(5), 63. This paper describes the role of cash flow statement in an annual financial statement. Analysts have always evaluated cash flow using financial ratios which are used for comparison with prior years. Based on the paper, the Financial Accounting Standards Board describes the role of financial cash flow statement including: assessing the ability of an enterprise to generate future positive net cash flows; assess the ability of an enterprise to meet its obligations and pay dividends, and assess the reasons for differences between net income and associated cash receipts and payments.
- Corporate financial policy and the value of cash, Faulkender, M., & Wang, R. (2006). The Journal of Finance, 61(4), 1957-1990. This article examines the variation of marginal value of corporate cash holdings which arise from the difference in corporate financial policy. The article uses semi-quantitative predictions for the value of an extra dollar and derives a number of hypotheses to test empirically. The authors reveal that the marginal value of cash declines with larger cash holdings.
- A new method to estimate risk and return of nontraded assets from cash flows: the case of private equity funds, Driessen, J., Lin, T. C., & Phalippou, L. (2012). Journal of Financial and Quantitative Analysis, 47(3), 511-535. This paper develops a methodology used to estimate the abnormal performance and risk exposure of non-traded cash flow assets. The methodology used extends the standard internal RIO approach to a dynamic setting. The authors use some sample properties which are validated using a simulation study. As a result, it is found that there is low market beta with no evidence of outperformance.