Real Estate Yield. Understanding Your Cash-On-Cash Return
Whether you are new to commercial real estate, or a seasoned investor, understanding Real Estate yield, i.e. the numbers behind your acquisition, is especially relevant. For experienced buyers, the analysis might be used for comparative purposes, between various properties. For a new investor, it might be a tool to determine whether buying an investment property will provide you a return that betters what you might achieve in an alternate investment. As a result, you will want to know your Return On Investment (ROI), or yield.
There are various techniques to determine yield. For most investors, its about determining your return. This is most often a calculation which yields a percentage. It’s the annual return you will make on the funds (cash) invested. For this reason, it is most often referred to as a Cash-on-Cash return.
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.
Let’s consider an example:
In this example, the property generates $271,000 in gross income. Operating Expenses, including annual debt payments, total $212,600. The resultant net income of $58,400 is the “free” cash in your pocket at the end of the year. As a percentage of your initial cash (equity) investment, it implies an 8.3% cash-on-cash return.
Gross Annual Income $271,000
Annual Operating Expenses ($105,700)
Annual Mortgage Payments ($106,900)
Net Income $58,400
Equity (Cash) $700,000
Cash-On-Cash Return $58,400/$700,000 x 100 = 8.3%
You may conclude, after reviewing the example, that your cash-on-cash return will increase, with a lower initial cash investment. Keep in mind however that you will likely need to arrange a relatively larger mortgage, with higher total annual mortgage payments, which will result in lower net income as well.
Yield vs. Value
What has yield got to do with the value of your property? In a nutshell, not much. Market values can only really be estimated by reviewing recent sales data for comparable properties. Therein lies the challenge. Rarely are two properties so similar as to allow for a direct comparison in this manner. Inevitably they will differ in overall condition, location, and will have differing income generating characteristics. Property yield figures however, allow one to compare different property types to one another, in terms of the return one would expect to achieve. The variable of course, is the amount of cash (equity) you plan to inject.
Now that you know the cash-on-cash return on various potential properties, you can layer this with additional analysis. So 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.