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Cash-on-Cash Return on Investment
How Cash-on-Cash ROI Provides a Truer Profitability Metric With Leverage

Investments involving loans often evaluated with Cash on cash ROI
 

Cash-on-Cash ROI is a favorite metric of real estate investors, who often make short-term investments with temporary use of long-term loans.

The Cash-on-Cash ROI metric reveals the power of leverage when investing with borrowed funds.

What is "cash-on-cash ROI?"

The term "cash-on-cash" refers to a form of return on investment analysis (ROI) that considers only the pre-tax cash portions (or capital portions) of more substantial investments.

Investors often use "Cash-on-Cash ROI" for evaluating real estate investments, for instance, which typically involve long-term borrowing. In such cases, the Cash-on-Cash ROI for an investor who buys and then sells a property during the life of the loan can be quite different from the ROI that considers total investment costs.

Comparing Cash-on-Cash ROI to Simple ROI for Investments

Examples below compare Cash-on-Cash ROI with the more familiar ROI metric, simple ROI. Note especially that the illustrations show how investors increase or decrease profits by investing with loans or external funds. Cash-on-Cash ROI, in other words, reveals the power of investor leverage.

Examples below illustraemphasizing three themes:

  • First, tThe nature of the cash-on-cash ROI metric and unique information that it provides to those who make short term use of long-term borrowing to fund investments.
  • Second, three different ways that investors calculate Return on Investment, including cash-on-cash ROI.
  • Third, explaining how cash-on-cash ROI illustrates the power of leverage to either increase or decrease investor profits.

Contents

Related Topics

What is Return on Capital?
Return on Capital is Essentially the Business Firms Version of cash-on-cash ROI

Businesspeople sometimes use the term Return on Capital, referring to a similar ROI approach for investments or costly actions where investment costs are partially borne by the investing company with its "capital," while the investor covers the remaining costs through loans, grants, tax incentives, or some other kind of external funding.

In such cases, "Return on capital ROI" (just like "Cash-on-Cash ROI") shows the return on the investor's funds directly.

Note that "Return on capital" in this sense is different from a family of ROI-like profitability metrics that measure a company's ability to earn from its asset base or equity, such as Return on Invested Capital (ROIC), Return on Capital Employed (ROCE), or Return on Equity (ROE).

Investors Calculate Return on Investment ROI in Different Ways

Consider a property an investor buys for $1,000,000 on 1 January. One year later, the investor sells it for $1,200,000. Those with an interest in such transactions typically take one of 3 different return on investment (ROI) approaches to evaluating this investment.

Investor ROI Metric 1
First Pass Simple ROI

A first pass simple ROI for this investment results entirely from the two figures given above:

Simple ROI = (Investment Gains – Investment Cost) / (Investment cost)
                      = (1,200,000 – 1,000,000) / (1,000,000)
                      = 20.0%

An investor might use this approach when making a first-pass comparison between a large number of competing investments, to distinguish the best investment prospects from the worst.

Investor ROI Metric 2
Cost Accurate ROI

The first pass simple ROI does not include the full set of Investment costs. Costs besides the original purchase price will appear for the investor each year the property the investor owns the property. Moreover, these additional costs can differ from year to year. Consider for instance the other actual cash payments for investment costs the investor makes during this one-year investment:

$2,400  Loan origination and loan closing fees
$9,600  Insurance and maintenance costs
$48,000 Twelve monthly loan payments ($38,000 interest + $10,000 principal)

These additional Year-1 costs total $60,000

Cost-accurate ROI = (Total Gains – Total Investment Costs) / (Total costs)
                      = (1,200,000 – (1,000,000 + 60,000 ) / (1,060,000)
                      = 13.2%

Note that if this property were an income-producing property, the total gains could increase as well as the total costs, With such gains, the cost-accurate ROI would be higher than the 13.2% shown.

Investor ROI Metric 3
Cash-on-Cash ROI

Cash-on-Ccash ROI focuses only on the real pre-tax cash inflows to the investor and the outflows the investor pays by the close of the investment. Assume the following:

  • This example investment is not an income producing property. Otherwise, there could be gains in addition to the sale price of $1,200,000.
  • After one year, the investor's actual cash payments are as follows:

    $200,000  Initial down payment
    $2,400  Loan origination and loan closing fees
    $9,600  Insurance and maintenance costs
    $48,000 Twelve monthly loan payments ($38,000 interest + $10,000 principal)

    Total Cash payments = $260,000
  • After one year, when the property sells for $1,200,000, the investor's total cash payments are $260,000 (including the down payment), and the remaining loan balance after one year is $790,000.
  • When the investor pays off the $790,000 remaining loan balance from the $1,200,000 sale price, the total cash returns on this investment are $410,000.

The Cash-on-Cash ROI" is thus:

Cash-on-Cash ROI = ($Total cash gains – Total cash costs) / Total cash costs
                              = ($410,000 – $260,000) / $260,000
                              = 57.7%

ROI Conclusions
What is the Real ROI From This Investment?

What's the real ROI from this investment? The example figures above led to three different results for the same investment:

  1. First-pass simple ROI: 20.0%
  2. Cost-accurate simple ROI: 13.2%
  3. cash-on-cash ROI: 57.7%

In reality, most investors base investment choices on results of the third metric above, the "cash-on-cash ROI." Note, however, that none of the above ROI figures by itself considers investment risk, that is, the chance that the property will not increase in value as the investor hoped.

The Downside to Leverage: Greater Risk

For the investor who does perform a risk analysis, the "cash-on-cash ROI" is most useful for showing the range of possible investment outcomes. Suppose instead all of the same investment costs shown in this example, but instead of selling at a gain, the investor sells the same property after one year for the same $1,000,000 as the purchase price. In that case, the cash gains from the sale are $210,000 and "cash-on-cash ROI" becomes:

cash-on-cash ROI = ($210,000 – $260,000) / $260,000
                                   =  –19.2%.

Or, suppose instead that the investor sells after one year for less than the purchase price, at $900,000. In that case, cash gains after the sale are $110,000, and "cash-on-cash ROI" is:

cash-on-cash ROI = ($110,000 – $260,000) / $260,000
                                   =  –57.7%.

Winning vs. Losing with Leverage Depends on the Economy

Comparing the several "cash-on-cash ROI" figures shows most clearly the effect of leverage (operating with borrowed funds) on possible gains and possible losses, depending on whether the economy (or market prices) improves or worsens.

For more on defining and measuring leverage, see Leverage metrics. For numerical examples showing positive and negative results of "leverage," see Capital and financial structure.

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