Defining Cash-On-Cash Returns

Defining Cash-On-Cash Returns for Private Equity Real Estate Syndications

Real Estate Private Equity (REPE) investors can employ any of a good many of the metrics used to measure the performance and profitability of potential and actual investments.

 Well-known metrics include Internal Rate of Return (IRR) and Return on Investment (ROI). Although cash-on-cash (COC) is not as widely known, it is a simple tool that REPE investors use frequently to assess performance and profitability.

 So What Are COC Returns as they Apply to REPEs?

COC calculations measure a property’s net income, potential or actual, as compared to the initial cash investment to acquire the property, which may include certain expenses and funds for upgrades or renovation. The COC calculation, which calculates annual cash flow, may also factor in the financial effect of debt, i.e. interest expense, closing costs, etc.

The product of the COC calculation is of significant value to the investor, and can aid in determining an overall ROI. The COC method is occasionally referred to as Return on Equity (ROE) and sometimes as the cash yield.

The COC formula is also used to screen investments in commercial real estate, which have long-term debt commitments. It is one of the most commonly used tools—hands down.

What Is the Significance of COC Returns?

 The potential profitability of a real estate deal is determined using the COC formula, and because the formula comprehends debt, interest expense, etc., it helps investors choose the best financing option. For example, a traditional mortgage vs. a private lender.

Investors that use the COC formula consistently use COC as the basis for comparing the profit potential of various investment real estate and gain an understanding of how each impacts the performance of the broader portfolio.

 Everything being equal, COC comparisons to similar projects can be a reasonable indicator of how they compare, especially when management and operational costs are factored in to derive the Net Operating Income (NOI).  

When Should I Use the COC Formula?

 COC is the go-to formula for analyzing a potential deal, but it is also ideal for looking at the effects of fluctuations in future rentals and other variables so the investor can continually evaluate an investment’s performance.

Understanding the Differences Between ROI and COC

 Although often used interchangeably, return on investment (ROI) and COC are not the same. ROI calculates the return on the total investment, whereas COC considers gains relative to cash spent out-of-pocket by reviewing current income compared to the total amount invested at a specific moment. In short, ROI is a documentary and COC is a snapshot.

 ROI comprehends the total cost of the investment when determining profit, measuring the time value of money to reach an IRR. ROI calculates the performance and return after the project has completed its life cycle.

 ROI, expressed as a gross number, is then divided into the gross total of the original investment, which yields the equity multiple.

 Both tools are useful to investors, but they are different!

COC Returns Vs. NOI

Net operating income (NOI) is one more profitability formula that is popular with investors of all stripes. It differs from COC calculations in that NOI does not account for debt service expenses, while COC does.

 NOI deducts utilities, repairs, staffing expenses, maintenance, etc. from the gross annual receipts generated by the property.

What Is an Acceptable COC Return?

 Because of multiple factors, there is no possibility of defining what makes up an acceptable COC return. These factors comprehend the stage the real estate cycle is in when the investment is made, comparisons to similar properties in the area, the individual investor’s risk-return appetite, and the investor’s aims.

 For example, in an appreciating market, investors may accept a lower current return.

 All that said, most investors aim for a COC return in the 8 to 12 percent range, although, in certain markets, 5 to 7 percent would be acceptable.

 Regardless, it is noteworthy that COC return rates can vary widely because of out-of-pocket spending and cash flow structure.

Pros of Using COC

 Simplicity is COC’s strong suit. The COC formula only addresses the ongoing cash available for distribution. The formula does not consider any appreciation of the property’s value.

It is a simple formula that can provide an indication of immediate returns, which allows a unique insight into ongoing passive income and current yields, making it a useful metric for potential investors interested in knowing the immediate income a property can generate. It is helpful to investors/partners concerned about consistent positive cash flow.

Cons of Using COC

 The simplicity of the COC formula also reveals its weaknesses. The formula relies on limited information and does not comprehend tax implications, debt levels, property appreciation, a resale, future cash flow, or the time value of money (compound interest).

 While the COC can summarize the investment’s potential, it is not comprehensive and should not be the only analytical tool used to evaluate an investment opportunity.

How Risk/Return Profiles affect COC Returns

 As alluded to earlier, the investor’s risk/return tolerance is key to determining an acceptable COC score.

 For example, new construction is perceived to be high-risk and will probably yield a zero COC return in the build and lease phases. Once the cash flow is positive, however, returns may exceed those of mature ventures in the area.

 Risk-return profiles also need to be considered in value-add apartment investments. In the early stages of renovation, as tenants leave, COC returns will be substantially lower than when the renovation is complete, rents rise, and rates of vacancy plummet.

COC Returns and Real Estate Cycles

 When real estate cycles lengthen, COC returns will decline. Returns will be significantly higher in the early stages of an economic recovery, as rental prices, following an economic downturn, are lower because of the absence of market liquidity.

 Investors perceive the risk of real estate investment to be higher, as many investors are recovering from hard times. When the economy recovers, however, more investment funds will enter the market, inflating prices and causing COC returns to decline. Interest rates also rise in the later stages of the cycle, increasing debt service expenses and further exacerbating COC returns.

 An extended real estate cycle mitigates financial pains associated with the earlier downturn, and investors will assume greater risk for lower COC returns.

Using Leverage to Enhance COC Returns

 Investors usually buy real estate through borrowing and/or using existing equity. The equity is sourced from investor savings and, as we’ve learned, COC returns only apply to this type of capital. Therefore, using leverage (debt) by taking a mortgage loan, the COC returns are increased.

Calculating COC Returns

 This is the straightforward formula used to calculate the COC return:

COC Return = (Annual Cash Flow divided by the Initial Cash Outlay) x 100%

Of course, this entails calculating the annual cash flow, which is the net rental income after expenses.

Examples of recurring expenses to be deducted from gross revenues include:

-  Maintenance & repairs

-  Utility expenses (water, electricity, gas, etc.)

-  Operating staff expenses

-  Property management fees

-  Home Owners Association and similar fees (if applicable)

-  Debt payments

-  Insurance & Property taxes

Most of these recurring expenses can be found in the itemized operating budget, which shows both gross revenues and expenses, making these costs easy to identify. Revenues from other sources, such as parking fees, extra charges for air conditioning, extra cleaning or laundry services, etc. should be included in the gross revenues.

 Once the monthly net revenue has been established, it can be converted to the annual cash flow.

 Then calculate the initial cash investment and/or capital contributions to acquire the property. That includes the deposit, down payment, closing costs, and any improvements or repairs made to the property.

 Once the annual cash flow and total cash outlay are known, use the above formula to get the result.

It is worth noting here that a COC return is the investment return based on the investor’s initial capital and/or equity outlay, not the total outlay for the project.

 Therefore, the COC is often called return on equity.

Conclusion

 COC allows investors to measure returns as a function of cash flow and helps the investor decide whether a potential deal is viable. It provides insight into the size of the deposit or down payment an investor should consider. The COC return analysis is an excellent resource to get a quick snapshot of return on investment.

Obviously, a variety of other, often more sophisticated, analytic tools and metrics to analyze REPE deals exist, including IRR, the loan to value (LTV) ratio, analysis of capitalization rates, and so on. However, COC is a broadly accepted in real estate and is of value when discussing investment potential with partners, shareholders, etc.

COC is also useful for gauging the effect of operating costs on returns. What it won’t do is reveal the overall income or the level of risk involved in the investment.