Cash-On-Cash Return. Is there more to Real Estate Yield?
In our post entitled Real Estate Yield. Understanding your Cash-On-Cash Return, we spoke about the relevance of understanding Real Estate yield. Its an important tool for determining whether an investment property purchase will provide you the return that might be available to you in an alternate investment.
The annual return you derive from your real estate investment, on a funds (cash) invested basis, is referred to as your Cash-on-Cash return. Its a common, and very useful indicator of performance.
As the name implies, a Cash-On-Cash return provides you with an annual return on the capital invested as a percentage of the net income of the property. All annual operating expenses and mortgage payments are deducted. It has no bearing on the price paid for the property, or the actual net income. These figures are all relative to one another. A small walk-up apartment can generate the same Cash-On-Cash return as a large shopping center. It’s dependent upon the relative amount of equity invested, and the amount of debt placed on the property.
Are there other considerations?
In isolation however, while the Cash-On-Cash return tells a compelling story, its not the complete story.
Though arguably deviating from a true yield calculation, there are other considerations which reveal, perhaps more subjectively, how successful your property is performing.
What about Principal Reduction?
From my perspective, (likely my bias as a former Lender) first and foremost is loan amortization (or principal reduction). Some might argue (not incorrectly I might add) that a lengthy amortization on your loan is an efficient and effective use of leverage. It also certainly maximizes your Cash-On-Cash return. However take a closer look at the principal reduction annually. You’ll quickly see that this too has a bearing on your “return”. Perhaps you were clever enough to “finance out” at the outset, but if you’re like me, that doesn’t often occur on day one. Therefore I like to track my % equity growth on a cumulative annual basis. I like to see when I reach that tipping point when I have realized a 100% return of my original equity.
Is there another way to look at Property Appreciation?
Another important consideration is property appreciation. Why? While in isolation, appreciation does not generate cash, unless of course you sell the asset, it does generate additional room for increased leverage. Certainly a positive from an investors perspective! Appreciation is a positive consideration from the standpoint of eventual sale. Also think of appreciation as a tool for maximizing your borrowing capacity. I have met some investors who view real estate as less of an investment in bricks and mortar, and more of a vehicle to raise cash. Interesting take on things!
Depreciation is key.
Third is the ability to depreciate the asset. While available to all real estate investors, it is a hidden gem of real estate investing. The taxing authority you reside in will have a bearing on what rate you can depreciate your asset, and on what basis the tax man will assess your “recapture” upon sale, however the tax efficiency of real estate ownership is clearing one of the top motivators for Real Estate investors.
Yield vs. Value.
What has yield got to do with the value of your property? In a nutshell, not much. Property yield figures allow one to compare different properties to one another, but strictly in terms of the return one can expect. Market value is the only true method to compare properties, however therein lies the challenge. Rarely are two properties so similar as to allow for direct comparison in this manner. The variable of course, is the amount of cash (equity) you plan to inject.
View Cash-On-Cash returns as one of the tools in your toolbox. Now layer this with additional analysis. Is the 8% return on the multi-family property, better than the 7% return on the retail property? Perhaps not! This is where your due diligence is required. How secure is income? How long are the leases? What condition is the property in? Which location is better? How strong are the tenant covenants? All of these considerations, and several others, will lead you to narrow your choice, to the property best suited to your investment strategy.