Question from one of our readers: what is cash-on-cash return in a commercial real estate investment context?
Answer: At its most basic, cash-on-cash return is defined as annual pre-income tax operating cash flow (annual Net Operating Income less Financing Costs less Capital Costs) divided by the total cumulative cash investment in the property. However, there is some nuance here that needs to be detailed to make sure we fully grasp what exactly the cash-on-cash return in a particular yearly period represents.
(Note: We assume all equity is invested at time zero, a simplification made for the purpose of teaching cash-on-cash as a concept in isolation.)
Nuance #1: Return OF capital vs. Return ON capital
“Capital” is typically synonymous with cash equity investment, so when we talk about return OF and ON capital, we are talking about the total cash dollars invested in the transaction. Return OF capital is exactly what it says, the repayment to the equity investors from the property’s operation (and property net sale proceeds if all capital is not repaid through operating cash flow) of the equity investor dollars invested.
Return ON capital is the payment of profit amounts to the equity investors from the property operation and sale (assuming the property is operating profitably, and assuming it is sold at a cash gain).
So we need to be careful that we don’t misinterpret what cash-on-cash reflects in those initial periods during which the invested capital is still being repaid to the cash investors. For example, in the embedded file above, where the cash investment was $1.111 million, the cash-on-cash percentages in Years 1 through 3 (where cash flow to equity totals $850,000 cumulatively) simply show the portion of the original capital invested being repaid in each of Years 1 through 3.
Year 4 is a combination of both return of capital and return on capital, as the cash flow in that year repays the final dollar of cash invested, as well as pays profit.
Years 5 and 6 are pure profit payment, so their cash-on-cash measures truly reflect a “return” in the way in which a return is traditionally thought of (i.e, profit).
This brings us to Nuance #2: How are we defining and thus measuring capital in each period?
This is where it sometimes gets even cloudier. How is the person reporting cash-on-cash return percentages defining the denominator, “capital”? As stated above, capital is usually thought of as the total cumulative amount invested, but in some cases capital is arbitrarily defined as the net cumulative invested capital amount as of the beginning of each year, meaning that the denominator in our calculation, assuming some capital has been returned on a net basis to date, becomes a lower value than what it was originally when all capital invested was still in the transaction.
See below where we now include a set of lines for calculation of net cumulative invested capital (beginning of period balance less all cumulative repaid capital).
As you can see in the example directly above, if we define cash-on-cash based off of the net cumulative invested capital amount, we get values that differ from our original calculations (in the very top embedded file) in all but Year 1, where the beginning of period balance and net cumulative balance are equal to one another.
This brings us to Nuance #3: Whose cash-on-cash return are we talking about? And why might that matter?
In a multi-party cash equity transaction, there are actually multiple cash-on-cash returns metrics: that at the overall transaction level, and those for each of the individual cash equity investors, as broken out in lines in lines 23 and 28, and 24-25 and 29-30, respectively, in the embedded file below.
As you will notice, we show the returns for all parties using both definitions of the denominator “cash” value. We assume in these lines that dollars are returned parri passu (pro-rata to how they were invested, simultaneously) to the equity players, and that there there is no carried interest/promote structure in place (another assumed simplification for the purpose of teaching cash-on-cash as a concept in isolation).
In the instance of a promote structure, the cash-on-cash returns for the sponsor vs. investor would begin to diverge from the property level and from one another after the point at which the first negotiated performance hurdle had been exceeded.
So what are the final takeaways here? Which of the calculated values are the right ones?
The most important takeaway is to understand and be transparent about how the cash denominator value is being calculated in each period. As long as within that approach the math is sound, all of the values are “right”. Unfortunately, there are no official definitions handed down on stone tablets. So ask the questions you need to ask; don’t assume.