Cash on Cash Return is a calculation or metric that real estate investors use to estimate a real estate property's return on cash in year one. This isn't a very complicated calculation if you know what you are doing but software certainly helps make it easier.
First, to get started, you need to know how much of the property you plan to buy with cash, and how much of the purchase price you will finance with a mortgage. Next, you'll need to factor in any additional cash you plan to invest to renovate, or maybe the cash that you will pay in fees to acquire the property. These two items will add together to equal your total cash invested in the property.
Next, you'll need to estimate your year 1 rental income. This should be your rental income for one month multiplied by 12 minus any vacancy you may have in year one. Like many things in this calculation, it will only be as accurate as your real estate estimates. Once you have this number, hold on to it for later.
Next, you'll need to determine what you mortgage interest payments will be in year one and add them to your other expenses such as property taxes, insurance, and/or HOA fees.
Following that, you'll need to estimate depreciation expenses. If you are buying a residential property, this can be done by taking your purchase price, and dividing it by 27.5. This will be an estimate of your annual depreciation expense. Check out one of our other videos for an explanation on depreciation. In short, depreciation is an expense that doesn't cost us money, but is an expense you can deduct from your income in order to avoid a portion of your income taxes.
Now that you have your total revenue or rental income and expenses in year one, we need to subtract your expenses from your revenue. It is very possible that after subtracting your depreciation and your operating expenses that you have income of 0. If you have 0 income, this means that you won't have to pay any income tax in year 1 which is good news.
If you do have income, then you will take your net income after expenses and multiply it by your marginal tax rate or your tax bracket. This will be an estimate of your tax related expenses on the property in year 1.
If you have tax related expenses, subtract those from your net income.
Finally, in order to calculate our net cash flow, you'll need to add your depreciation expenses back into your net income. We do this because rental property depreciation is not a cash expense.
And lastly, you'll need to subtract the principal payment portion of your mortgage from this number to arrive at your final Year 1 Cash flow.
