What Is Cash On Cash Return?
Cash on cash return is a way to measure the success of an investment. It is most useful for cash flowing investments.
The numbers needed to do the calculation are:
- The amount of up front cash needed to purchase the investment
- The amount of cash generated by the investment in one year
Cash flow investors use cash on cash return to measure how quickly they can get back the money they put into an investment.
Calculating First Year Cash On Cash Return
Here’s the formula:
Annual cash flow is the amount of revenue the asset generated in one year minus all expenses incurred that year.
Your initial cash investment is the amount of money you spent before the investment began positively cash flowing.
How Is It Used?
I use the cash on cash return calculation for two things.
- To analyze the performance of investments already purchased
- To predict the performance of investments I’m considering purchasing
The percentage you calculate shows how long your initial cash investment is wrapped up in an investment.
Say I spent $10,000 of my own money to purchase an investment. Then I calculate my cash on cash return to be 25%. This means I will have made back 25% of my investment after one year.
It also means I can expect it to take about 4 years until my $10,000 is back in my bank account.
When I’m evaluating a potential investment I have a minimum expected cash on cash return in order to buy. For me that number is 20%. If I can’t expect my initial investment to be paid back in 5 years or less, then I don’t buy.
I use the calculation on past investments as well. It shows me how accurate my past predictions were and helps me make more educated guesses on what I can expect from future investments.
Why Use It?
While the stock market investor tends to look at the power of compound interest, the cash flow investor looks at the power of acquiring cash flowing assets over time.
Generally it takes quite a bit of money to purchase a cash flowing asset. You may be able to buy into the stock market for $100 or less, but in order to purchase the best cash flowing assets (real estate and businesses) you generally need thousands of dollars.
When you spend $20,000 or more purchasing a piece of real estate, you likely won’t be able to invest again until you have another $20,000.
The speed with which you can acquire wealth is limited by the amount of cash you have to invest.
That is why cash on cash return is such an important metric. It helps you gauge how quickly you will be able to reinvest.
And of course, the higher your return, the faster you can buy more cash flowing assets and the faster you build wealth.
When Not To Use It
Sometimes cash on cash is not a useful metric for determining the viability of an investment.
This evaluation is only useful to analyze cash flow and the amount of time needed to recoup your cash up front. If those two things are not important for an investment decision, then this computation will not be helpful in your analysis.
Any investment that does not produce cash flow, such as a 401k or traditional stocks, always has a zero percent cash on cash return. That doesn’t necessarily mean those are bad investments, but cash flow is not part of their model.
The cash on cash return formula needs to be in every investor’s toolbox. And you should know what your minimum return number is when considering the purchase of a new asset.
The faster your investments can return money to you, the more investments you can acquire.