Cash-On-Cash: The real measure of rate of return

By Andy Friedman

Real estate investors are always drawn to cap rate as their go-to measure for potential investments. Cap rates are flawed. (More about that in a previous post.) Your return is not the cap rate, it is the cash-on-cash return, especially since the majority of commercial real estate purchases are financed with a loan.

Cash-on-cash return can be defined by subtracting debt service from net operating income, then dividing that number by equity invested. This is different than the cap rate equation which is net operating income divided by purchase price. 

Cap rate calculation for an example property:

• Net operating income- $70,000
• Purchase price- $1,000,000
• Cap rate- 7%

That’s easy enough, but let’s look at the numbers when you put down 25% and borrow 75% at 4.75% interest on a 30-year fully amortizing loan.

Cash-on-cash return calculation for an example property:

• Net operating income- $70,000
• Debt service- $46,944
• Cash flow- $23,056 ($77,000 NOI – $46,944 debt service)
• Equity investment- $250,000
• Cash-on-cash return- 9.22%

This shows that an investor purchasing this property will get a 9.22% return on his/her money, not 7%.  Now let’s look at what happens when we drop the net operating income down to $55,000 and keep all other inputs the same.

Lowered operating income:

• Net operating income- $55,000
• Cap rate- 5.5%
• Cash flow- $8,056 ($55,000 NOI- $46,944 debt service)
• Cash-on-cash return- 3.22%

Between the two examples, lowering the cap rate by 150 basis points caused the cash-on-cash return to drop a whopping 600 basis points. An interesting thing to note here on the second example is that although the loan rate is lower than the cap rate, the added principal payments make the monthly debt service higher than the debt’s share of net operating income, in effect a loss.  To go to an extreme, if you financed 100% of the property with a 5.5% cap rate with the loan terms above, you would have to feed the investment $7,592 per year. 

The above examples show what is a very important driver of real estate yield- the spread (difference) between cap rate and financing cost.  In Chicago core markets, cap rates have been for the most part steady over the last two years, but financing costs have gone up considerably, resulting in lower cash-on-cash returns.  Did Chicago multifamily get more expensive in the last two years or did it stay steady?  It just depends on what metric you use to judge it.