If there’s anything we need to get out of the way when it comes to real estate investments, it’s that any form of investment involves a certain amount of risk. This is why in order to become a successful physician investor, you must turn to reliable metrics such as cash on cash return to determine whether an investment is worth getting into or not. In identifying whether an investment is worthwhile, there are no shortcuts and a great deal of good old-fashioned number crunching is an important step in every process. Luckily, there are a handful of simple equations you can utilize to help visualize how certain real estate ventures may pan out. Computing whether an investment can provide good cash on cash return is a form of due diligence that helps you maximize income, minimize risk, and make financially sound investment decisions.
Seasoned physician investors understand that the valuation and appreciation of a property investment is dependent on factors such as, but not limited to, location, demographics, current economic landscape, and more. Apart from doing your research on the neighborhoods you wish to be part of, another form of due diligence is to map out your expected annual returns. Put simply, cash on cash return is defined as the rate of annual return used in real estate transactions which calculates the cash income earned from the out-of-pocket cash you invested in a property.
Also referred to as the equity dividend rate, cash on cash return is a fairly simple formula that computes the ratio of cash earned to cash invested, but does not include taxes and debts incurred to acquire the said property. The cash on cash return formula is as follows:
Annual Pre-Tax Cash Flow / Total Cash Invested
where Annual Pre-Tax Cash Flow stands for:
(Gross Rent + Other Income) – (Vacancies + Operational Expenses + Annual Mortgage Payment)
The Total Cash Invested number should include all of the capital which you shelled out of your own pocket – debt not included. This number usually includes all actual cash invested, upfront repair or maintenance costs, and loan down payments.
The Annual Pre-Tax Cash Flow includes all cash on hand after expenses and losses have been accounted for. This number usually includes your projected annual rental income (including any other additional means of income generated by the property) minus all monthly expenses to be incurred (utilities, maintenance costs such as landscaping, pest control, and the like).
Once you have both of these numbers figured out, you simply divide the Annual Pre-Tax Cash Flow by the Total Cash Invested. Multiply by 100, and there you have it – cash on cash return.
Based on experience, it’s always tricky to figure out how to best assess an investment opportunity and it never hurts to proceed with caution. This is why equations like cash on cash return exist. In real estate, it is a metric that is normally used to gauge the profitability of an investment property. It projects the cash yield an investor can possibly get out of a real estate investment. While it definitely has its own pros and cons, the cash on cash return formula provides investors with a bird’s eye view of a potential investment, from cash distributions to overall investment performance per annum.
Another important detail the cash on cash return formula reveals is an estimate of how long it will take before the investment ripens. For example, let’s say you invest $10,000 into a real estate syndication (Total Cash Invested) and you receive $1,000 over the course of a year (Annual Pre-Tax Cash Flow). This means that this investment will yield a 10% cash on cash return [($1,000 / $10,000) x 100], and it will take approximately 10 years for you to get back 100% of what you invested plus profit.
Like any other investment performance metric, cash on cash return has its strengths and weaknesses. Here are important points to consider when referring to cash on cash return as a metric for your investment decisions.
While cash on cash return definitely has a bunch of benefits to boot, we advise you not to be totally reliant on this number alone. Cash on cash return is great at helping you assess the potential value of a real estate investment but it shouldn’t be your only criteria for getting into an investment. In conclusion, investment decisions should always be based on the whole picture – we cannot stress this enough. Keep in mind that the metrics you utilize should also be relative to the goals you wish to achieve for each investment, may it be appreciation or positive cash flow.
Here at PhysicianEstate, we welcome all physician entrepreneurs to learn about commercial real estate investments, rental property investments, and wealth generation. We encourage all physicians to eventually become real estate physician investors. We know a great deal about Who – What – Why – How.
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