Evaluating Real Estate Investments — Cash-on-Cash Return | Whitman Legal Solutions, LLC
Most serious musicians eventually need to learn music theory. Like studying grammar in learning a language, music theory helps musicians understand how music is structured.
Music consists of a combination of pitch (single note), horizontal (multiple notes are played in sequences to create a melody), vertical (multiple notes are played simultaneously to create harmony), and rhythmic elements. In combination, two or more of these elements create a unique composition.
Music theory is a framework for describing how these four musical elements are combined to create a composition. Music theory also includes studying the rules and conventions of composers from different eras and composing schools combine the elements. For example, the harmonies of a Bach composition differ significantly from those of today’s jazz.
Like music theorists, real estate investors have methods of describing the valuation of a property. At the most basic level, real estate investors are concerned about how much money they will need to invest in the property (what I call “cash-in”) and how much money they will get from the investment (what I call “cash-in”). the end”).
As with music theory, there are several methods investors use to evaluate profitability. But they all start by looking at the deposits and withdrawals.
This article is part of a series on the ways investors evaluate the return on investments. This article deals with the “cash-on-cash return”.
What is the cash return?
Cash-on-cash return calculations take into account only two numbers: the money an investor has invested in the property and the annual money the investor receives for the investment. The formula for the cash-on-cash return divides the annual cash out (annual cash distributions) by the total cash in (total cash invested in the property):
Cash-on-Cash Return = annual payout / total deposit
The cash-on-cash return is usually expressed as a percentage. For example, if an investor pays $ 1 million for a property and receives $ 50,000 in cash annually from the investment, the cash-on-cash return is five percent (5%).
How can cash-on-cash return be used to evaluate an investment?
The cash-on-cash return is helpful for investors who are focused on the annual income from their investment. A cash-on-cash return assessment can help investors compare two investments that require the same cash outlay.
Cash-on-cash yield is a reasonable substitute for investment interest. Hence, it can help investors to compare a real estate investment with other types of investments.
Consider this example:
Maria and Jessie are a retired couple who depend on their capital income to top up their social security. You have a $ 1 million long-term certificate of deposit that offers just one percent (1%) of the interest or $ 10,000 in cash per year. With their increased cost of living, they need at least $ 30,000 a year in cash on their investment to avoid having their money withdrawn from their client. Your investment options are to invest $ 1 million in any of the following:
1. An apartment building real estate investment with a cash-on-cash return of 3.5% ($ 35,000) for seven years and a return on investment of $ 1,000,000 if the property is sold at the end of the seventh year.
2. Unqualified annuity from an AAA rated insurance company that pays $ 50,000 annually for 25 years.
3. A $ 1 million AAA rated corporate bond with an annual interest payment of 3.5% ($ 35,000) over ten years and a return on investment at the end of the tenth year.
4. An AA-rated $ 1,000,000 tax-exempt bond issued by the State of Maria and Jesse that pays 3.4% interest ($ 34,000) annually for seven years, with the capital is repaid at the end of the seventh year.
Looking only at the cash return, Maria and Jessie buy Investment 2 because it gives them the highest annual income and guarantees that income for 25 years, much longer than the other investments.
What cash-on-cash return does not evaluate
The cash-on-cash return provides an easy way to compare investments and can be useful for investors who need cash income from their investments. However, when calculating the cash-on-cash return, several factors are neglected that can be important when evaluating an investment, especially when, as in the example above, the cash return on a real estate investment needs to be compared to the cash return on other types of investments.
The cash-on-cash return does not take into account the tax advantages (or disadvantages) from investments. More importantly, the cash-on-cash return does not take into account the risk of default over the investment period. A cash payment also does not take into account the time value of money, a complicated concept that is beyond the scope of this article.
In the example above, attachments 2 and 3 (the bond and corporate bond) are rated AAA, the highest investment rating. So you have the lowest risk of failure. Investment 4 (the tax-exempt bond) has a strong AA rating, so the risk of default is low.
Most real estate investments are not rated. This does not necessarily mean that they have a higher risk of default than rated assets.
However, the investor must carefully examine the investment’s financial projections to assess the risk of default and whether the underlying assumptions are conservative, aggressive, or somewhere in between. Most investors have neither the experience nor the interest to delve deep into the forecasts to make this assessment.
Plant 2 and 3 are the winners simply because of the risk of failure.
The cash payment does not evaluate the tax benefits (or disadvantages) of an investment. For example, let’s say Maria and Jessie have a combined state, state, and local income tax bracket of 30%.
Investment 1 is a real estate investment and will result in depreciation to offset part of Maria and Jessie’s cash return. For example, let’s say 10% of the $ 1,000,000 investment is in land and 90% is in the apartment building. The land is not depreciable and apartment buildings are depreciated over 27.5 years.
In that case, Maria and Jessie would receive a depreciation amount of $ 32,727.27 each year, which would reduce their taxable income on the investment. That would save them about $ 9,818.18 in taxes each year as they would only pay tax on $ 2,272.73 of their cash income, which equates to a total annual tax liability of $ 681.82
Investment 2 is a pension. To simplify the calculation, although Maria and Jessie would receive $ 50,000 a year, 80% or $ 40,000 of that money would be a non-taxable return on part of their original investment. That means they would only pay tax on $ 10,000 of the cash and have a total tax liability of $ 3,000.00.
Investment 3 is a corporate bond, so the entire $ 35,000 Maria and Jessie receive each year would be taxable. They would pay $ 10,500 for their annual return.
Investment 4 is a tax-exempt bond. Assuming that your state does not tax interest on its own bonds, your total income tax liability on Investment 3 would be zero.
If you only look at the tax implications, Investment 4 is the winner.
What about real estate?
You may have noticed that real estate investing wasn’t the winner in any of the reviews in this article. While the cash-on-cash return is often used to evaluate real estate investments, it does not give a complete picture of the benefits of investing in real estate.
As shown above, real estate investments with depreciation allowances can provide a legal way to protect income from taxes. As far as § 1031 is available, real estate investors can legally defer their profits from real estate investments.
Real estate can help investors diversify their portfolios to minimize portfolio risk. And real estate can be a good hedge against inflation.
Real estate can also increase in value. So the biggest benefit for real estate investors is the profit if the property is sold, rather than the cash income they receive while holding the investment.
Cash-on-cash doesn’t give the whole picture
Music theory doesn’t just look at melody or rhythm. It analyzes entire compositions. Investors should do the same.
The examples in this article make basic assumptions to show the limits of cash-on-cash return when valuing investments. Actual investments and tax situations are likely to be more complex, especially when it comes to real estate investments.
While cash-on-cash returns are easy to calculate and can provide a basis for comparing real estate investments with other types of investments, this metric does not provide a complete picture. And as investments and tax situations become more complex, cash-on-cash returns are less likely to reflect the full picture of an investment. Cash-on-cash return analysis can be useful for investors realizing their limitations, but it is just one of many tools a potential investor should use in making an investment decision.
This series draws on Elizabeth Whitman’s background and passion for classical music to illustrate creative solutions to legal challenges faced by businesses and real estate investors.