Cash on Cash Return
Cash-on-Cash Return (we will refer to it in abbreviated terms as COCR) is a return measure calculated as the before-tax equity cash flow over the equity investment. It is also referred to as equity dividend rate.
This measure of return is used very often in the case of property investments because the financing of property acquisitions involves typically the use of both equity and debt (borrowed funds).
Actually, investors using using borrowing funds are advised to estimate the COCR as opposed to a simple overall income return that does not take into account loan payments and the distinction of investment cost to loan and equity. The formula for calculating the COCR is:
COCR = BTECF / Equity investment
BTECF = Before-Tax Equity Cash Flow
Equity Investment = Total Investment Cost – Loan Amount
In the case of property investments that are partially financed with borrowed funds, BETCF refers to the equity cash flow, that is, the income the investor receives net of debt service (loan or mortgage payments). Within this context, the BTECF for a property is calculated as:
BTECF = Net Operating Income - Debt Service
Example of Cash-on-Cash Return Calculation
To demonstrate the calculation of COCR, consider a property investment with a total acquisition cost of £1,000,000, an annual NOI of £100,000, and a £700,000 mortgage loan. The loan interest rate is 6% and its term is 20 years, which implies an annual debt service of £61,029.19 (if it is repaid annually). With these figures the COCR can be calculated as follows:
BTECF = 100,000 – 61,029.19 = £38,970.81
Equity Investment = 1,000,000 – 700,000 = 300,000
With these two figures we can now estimate the cash-on-cash return as:
COCR = 38,970.81 /300,000 = 12.99%
Problems of Cash-on-Cash Return as Performance Measure
The cash-on-cash return has serious limitations as a measure of property investment performance. The most important is that it does not account for potential changes in net operating income and property value in the years subsequent to the year that this measure is calculated. To demonstrate this point, consider the case that the property has a large lease representing 70% of the total leasable space, which is expiring in the next year and has a contract rate significantly above market rents. When this lease expires and the tenant renews at market rents, the NOI of the property and, therefore, its COCR will drop significantly. If the tenant does not renew and the space remains vacant for some time before a new tenant is found, the decrease in NOI will be even greater. Thus, any of these two developments will reduce drastically the cash flow of the property but this potential deterioration in investment performance is not captured by the COCR since it is calculated using the current NOI of the property. In addition to any changes in the NOI of the property, the investor may realize capital gains or losses depending on how cash flows and cap rates will move, but none of such potential gains or losses can be captured by the COCR.
Another problem with the COCR is that it fails to account for the income-tax implications of the investment, which may alter drastically the ultimate return delivered to the investor. A more complete and comprehensive methodology for estimating the return on a property investment is the discounted cash flow model.