A Comprehensive Guide to Analyzing Commercial Real Estate Investments with this often Misunderstood Metric
Intro
In this blog post, we’re going to explore the nuances of cash on cash returns within commercial real estate investments. We’ll cover what happens when the numerator and denominator change, and whether the metric is still valid once all equity has been returned. We’ll also provide a comprehensive Excel model template for calculating cash on cash returns.
Cash on cash returns represent the annual return an investor receives on their investment based on the amount of cash they put in. It’s calculated by dividing the annual pre-tax cash flow by the total cash investment. This popular metric helps investors evaluate the potential return on investment, but it has its limitations as a stand-alone criterion. Therefore, it’s crucial to consider other aspects of evaluating a deal’s profitability, such as net present value (NPV) and internal rate of return (IRR)
Throughout this blog post, we will cover various aspects of cash on cash returns in commercial real estate investment, such as leverage and its impact on cash on cash return, drawbacks of cash on cash return and alternative metrics, and exploring cash on cash return scenarios. We will also provide a detailed overview of the cash on cash return definition and its limitations.
Finally, we will share a custom-made Cash on Cash (CoC) Return Excel Template, designed specifically to help you analyze commercial real estate investments. This template offers a comprehensive framework for assessing potential investments while taking into account all relevant factors, regardless of the asset class.
By the end of this blog post, you will have a deep understanding of cash on cash returns in commercial real estate investment and be equipped with a valuable tool to assist you in making informed decisions about potential investments.
Cash on Cash Return Definition and Overview
Cash on Cash (CoC) return is a metric used to measure the cash flow generated by a property relative to the amount of cash invested. It is expressed as a percentage and calculated by dividing the annual pre-tax cash flow by the initial cash investment.
For example, consider a property that generates $50,000 in pre-tax cash flow per year and requires a total cash investment of $500,000. The CoC return would be 10% ($50,000 ÷ $500,000). This metric is useful for evaluating a property’s income-generating potential, particularly for investors prioritizing immediate cash returns.
However, it is important to note that CoC has its limitations and should not be the sole criterion for investment decisions. It is essential to consider other factors and metrics when evaluating a property for investment purposes.
Leverage and its impact on Cash on Cash Return
Leverage plays a significant role in cash on cash returns (CoC) for commercial real estate investments. Equity investors often focus on the levered cash-on-cash return, which takes into account the effects of debt on the investment. Financing terms can greatly impact CoC, and it is essential to consider these terms when calculating and interpreting returns.
Key factors affecting CoC due to leverage include:
- Interest rate: Higher interest rates lead to higher debt service payments, reducing the cash flow available for distribution and potentially resulting in a lower CoC.
- Loan term: Longer loan terms can lower debt service payments, increasing the cash flow available for distribution and potentially leading to a higher CoC. However, longer terms also mean a longer period before the property is fully owned, impacting overall returns and the ability to reinvest cash.
- Loan-to-value (LTV) ratio: A higher LTV ratio impacts the CoC return in two ways. First, it leads to higher debt service payments, reducing the cash flow available for distribution, reducing the overall CoC by decreasing the numerator. Also, a higher LTV reduces the equity in the CoC return, increasing the CoC by reducing the denominator.
- Amortization schedule: Shorter amortization schedules can increase debt service payments, reducing the cash flow available for distribution and potentially leading to a lower CoC.
- Inflation: Increasing inflation rates may result in changes to financing terms, which can impact CoC.
For example, let’s assume an investor financed their $500,000 investment with $400,000 of debt at a 7.0% fixed interest rate with no amortization. Interest expense would be $28k (7.0% * $400,000), leaving $22k of post-interest income for the equity investor against their initial $100k equity investment, resulting in a 22% cash-on-cash return.
Leverage can be a double-edged sword, as it magnifies both potential gains and losses. It is crucial to consider the impact of leverage and financing terms on CoC, as increasing debt levels can amplify both the upside and downside potential of the investment.
Drawbacks of Cash on Cash Return and Alternative Metrics
The cash on cash (CoC) is a useful benchmark for comparing the relative attractiveness of different investment opportunities. However, it has limitations and should not be the sole criterion for decision-making. In this section, we will discuss the drawbacks of CoC and suggest alternative metrics to consider when evaluating commercial real estate investments.One limitation of CoC is that it does not account for the time value of money. Although it does consider the impact of financing on returns, its meaning may change as investors are returned their capital through distributions. Since the equity denominator can change over time, the metric eventually loses meaning as the initial investment is recouped.
To address these limitations, investors can use other metrics such as internal rate of return (IRR), net present value (NPV), equity multiple (EM), debt coverage ratio (DCR), and debt yield to capture the full spectrum of expected returns and risks of an investment.
- Internal Rate of Return (IRR): IRR measures the rate of return on an investment over a period of time, taking into account the time value of money and any cash flows that occur during the investment period. A higher IRR implies a more attractive investment.
- Net Present Value (NPV): NPV calculates the present value of all cash inflows and outflows associated with the investment, taking into account the time value of money and the required rate of return. A positive NPV reflects an accretive investment opportunity against the investor’s cost of capital.
- Equity Multiple (EM): EM is the ratio of the total cash distributions to the equity invested. It provides a simple way to compare the total return on investment across different opportunities.
- Debt Coverage Ratio (DCR): DCR measures the ability of a property to generate enough income to cover its debt obligations, taking into account the income generated and the amount of debt owed. DCR is typically used from a credit investor’s perspective.
- Debt Yield: Debt yield is the ratio of a property’s net operating income to its outstanding loan balance. It represents the return a lender would receive if the borrower defaulted and the lender took ownership of the property. Like DCR, debt yield is also primarily used from a credit investor’s perspective.
When evaluating commercial real estate investments, it’s essential to consider multiple metrics in conjunction with each other. Along with the aforementioned metrics, other factors to consider include net operating income (NOI), capitalization rate, and t
otal return. By employing a holistic approach and using a combination of these metrics, investors can make more informed decisions about the potential profitability and risks associated with their investments.
Exploring Cash on Cash Return Scenarios in Commercial Real Estate Investment
Scenario 1: Changes in Rental Income
Improving the rental income can increase the cash flow and the CoC return, while a decrease in rental income can reduce them. For example, consider a property with a current CoC return of 10% ($50,000 cash flow ÷ $500,000 equity investment). If the property increases its rental income by $10,000 without adding more debt or equity, the cash flow will rise to $60,000, and the CoC return would increase to 12% ($60,000 ÷ $500,000).
Scenario 2: Changes in Operating Expenses
Reducing operating expenses can also increase the cash flow and CoC return. Conversely, an increase in expenses will reduce them. For instance, if the property from Scenario 1 decreases its operating expenses by $5,000 without affecting rental income, the cash flow will increase to $55,000, resulting in a CoC return of 11% ($55,000 ÷ $500,000).
Scenario 3: Changes in Equity Investment
Altering the equity investment can impact the CoC return. An increase in equity investment through contributions will decrease the CoC return, while a reduction in equity through distributions will increase it. For example, if the property owner in Scenario 1 reduces their equity investment by $100,000 through distributions, the new equity investment will be $400,000, leading to a higher CoC return of 12.5% ($50,000 ÷ $400,000).
Scenario 4: Changes in Financing
Securing more favorable financing terms can lower financing costs, which can subsequently increase the cash flow and CoC return. For example, if the property owner in Scenario 1 refinances their loan and reduces the annual interest expense by $5,000, the cash flow will increase to $55,000, and the CoC return will rise to 11% ($55,000 ÷ $500,000).
Scenario 5: Changes in Cash Flow Timing
Cash flow fluctuations due to lease expirations, renewals, or other factors can make the CoC return calculation more complex. For instance, if the property in Scenario 1 experiences a temporary vacancy, leading to a $10,000 reduction in rental income for one year, the cash flow will drop to $40,000 for that year. The CoC return will also decrease to 8% ($40,000 ÷ $500,000) during that period, before returning to its original level once the vacancy is filled.
Understanding the potential impact of various factors on CoC return is essential for making informed commercial real estate investment decisions. By analyzing different scenarios and their effects on the numerator (cash flow) and denominator (equity investment) of the CoC return calculation, investors can better assess the risks and rewards associated with their investments.
Excel Template
We are excited to provide you with our custom-made Cash on Cash (CoC) Return Excel Template, designed specifically to help you analyze commercial real estate investments. This template is a helpful tool for students and investors, as it offers a high-level framework for evaluating cash on cash returns, regardless of asset class.
Attached to this blog post, you will find our custom CoC Return Excel Template. This template provides an organized, high-level framework for assessing commercial real estate investments, improving the decision-making process for investors.
To access the template, simply sign in or register for an account. The download is available for free. If you’d like to watch how we built this template, the free YouTube video at the top of this post walks you through our process from scratch with shortcuts.
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