Cash On Cash And Why You May Not Wish To Worry About It

Cash on Cash10% Cash On Cash is the Holy Grail to a lot of real estate investors.  I just had the conversation again with someone in their very early thirties telling me why they needed a 10% Cash On Cash return.  That’s what his father had said he absolutely had to be sure of before buying an income property.   And if I was his father’s counselor I may or may not agree depending on his situation.  But for this younger man with great income, a solid future and a desire to build assets,  I couldn’t disagree more strongly.

REALTOR DISCLAIMER
Remember, as a professional real estate agent that works everyday with real estate investment property I have access to not only my own personal experiences but the personal experiences of people that, in total, own hundreds of rental homes.  I make it my business to talk to them and to tap their wisdom.  From those experiences I offer my advice after getting knowledgeable with each individual’s situation.  But ultimately, your decision is your decision.  I work for you.  Not the other way around.  Now, I may have you sign a disclaimer….   🙂

Listen to this very carefully.  To the extent that you chase Cash on Cash returns you retard your capital growth.  It’s really that simple.  Why?

  • Cash flow investment property with little to nothing down, at least here in the Kansas City area, tends to be in areas and neighborhoods that don’t appreciate very well in relationship to their surrounding communities.
  • For income properties that will appreciate at par or above, you will need to put more money down, i.e. 20% versus 10%, to get the higher Cash Flow Before Taxes to benefit your Cash On Cash returns. 

Take for example a Blue Springs, MO duplex I’ve been keeping my eye on. This particular rental property is about 40 years old (give or take) but has been nicely cared for, has a brick exterior with a newer roof, windows, carpeting, ceramic tile and more.  I’m sure the purchase price will be somewhere around $136,500 with the seller’s paying 2% closing costs.  Rents are $1,175/mo and it’s 100% occupied in a nice little quiet neighborhood that stays rented with quality tenants. 

Without showing you all my calculations here I can tell you that with 10% down on this property your cash flow is about $53 a year after all expenses calculated.  (And yes, I mean all.)  That translates to a 0.4% Cash On Cash return.  That’s right there with having a passbook savings account at Capitol Federal Savings. Not good.  But wait, there’s more!  (Apologies to Ronco.)  When you calculate Cash Flow Before Taxes, Principal Reduction and Depreciation your capital growth on your investment is 13.9%. 

Using the same income and expenses with 20% down, the corresponding lower interests rates and no PMI the Cash Flow Before Taxes jumps to $1,457 a year.  That’s a Cash On Cash return of 5.2%.  Now we’re getting better, right?  Well, no. Not really.  Because your capital growth has dropped from 13.9% with 10% down to this scenario at 10.6% capital growth. 

Note: No appreciation was used in the work-up of these numbers.  But what if it had?

Well, not only would your capital growth be better but you’d have two rental properties working for you where as before, with 20% down and better Cash On Cash you only have one rental property working for you. 

Are you following me here?

Heck, even if you are not believe me!  Or call me, come in an we’ll sit down and work-up a real property and by the time we’re done you’ll be able to teach me all about it.  Again, depending on your stage in life, investment goals, long term plans and available cash reserves this may not be the best strategy.  But for many, many, many people this argument will hold very true. 

11 Comments

Filed under 4 Benefits of Real Estate Investing, Investment Property, Real Estate Investing

11 responses to “Cash On Cash And Why You May Not Wish To Worry About It

  1. On Grandma’s head — that’s the best message you’ve ever published. If investors would just heed that principle their lives at retirement would be better than they’d dreamed was possible.

    Absolutely stellar — if I was there, I’d hug you.

  2. I’m uncomfortable with the hug. But I love the praises. 😉

  3. Jeff

    Chris,

    Thanks for the post, this one is a keeper. It helps me understand a bit more some of the details we discussed last week on the phone. Although not a Missourian (is that a word?), I’m a show me type of person. I’m interested in digging deep into the numbers when the time comes.

    Thanks again for a great article.

  4. Devil’s advocate here. You and the bawldguy are gonna double-team me on this one, but this is an argument that I don’t quite buy.

    The idea that “good” neighborhoods will, over the long term, appreciate faster than “bad” ones as an assumption that I eye with some suspicion.

    Yeah I accept the premise that the desirable location will consistently be pricier than then more downmarket digs. But appreciate faster? That, basically, is an assumption that the gap between rich and poor in America will forever expand.

    My observation is that pricey neighborhoods sometimes collapse in value, and shabby ones are sometimes gentrified. Now if I could accurately predict when this was gonna happen then I’d bottle it up and sell it.

  5. Jeff – Always work the numbers to see how they work and then compare them to your goals.

  6. Christopher,

    Fair enough on your argument. But I just don’t see it. Generally I recommend to my clients properties on the outer-rings of Kansas City where growth looks good for decades to come.

    Those very properties with their high growth potential, expanding populations and general “newness” (Is that a word? You are the Ivy Leaguer!) will almost always out-perform the properties where I can get you healthy C on C returns with 10% down.

    This isn’t an argument for, against or neutral on Rich America v Poor America. That’s a whole other topic that I’d love to discuss at length. Both sides have obligations there both in a moral and a business sense.

    And your argument that sometimes neighborhoods re-gentrify and sometimes neighborhoods collapse almost always takes longer than the 5-8 year window most of my investors will be holding.

    Your playing “devil’s advocate” is always welcome here. I know you walk the walk every day and your experiences are no less important than mine!

    If you readers haven’t read Christopher’s blog you should click his name and visit immediately. He’s a real estate investor from Houston and is not an agent in any way shape or form. So you get a little bit different view.

  7. Another Investor

    I’m not sure if good neighborhoods appreciate more rapidly than bad ones, although I suspect good neighborhoods generally appreciate more consistently. However, it’s a moot point for me. I care a lot more about the consistency of my rental income and my expenses, so I prefer middle class neighborhoods in close proximity to universities, hospitals, and other major employers that are likely to produce a demand from quality tenants.

    I would guess that 95 percent of your investor clients have neither the time nor the management skills to qualify and install tenants, order or make repairs, personally collect rent, or evict non-payers in low income neighborhoods. They are looking for properties they can turn over to a reasonably competent property manager and have the expectation of receiving a check almost every month.

    I also suspect that the cash on cash returns might not be as good as the spreadsheet says they will be in the weaker neighborhoods. Vacancy and collection losses, re-leasing costs, and other operating expenses are generally higher than in the stronger rental areas.

    Finally, with all due respect, in this market I have to disagree with you about the importance of cash flow. Cash flow insulates you against risk in a weak market. If vacancy goes up and rents go down, it’s easier to carry one property that then breaks even than it is to carry two alligators.

    I prefer to use high leverage and worry less about the immediate cash flow when the market is on the upswing and I am reasonably sure I can refinance out of the loan within a year or so. In a weak market, it’s better to look for deals and use cash or a large down payment as a negotiating tool.

  8. Chris: I’m no Ivy Leaguer – them’s fightin’ words.

    And in my rich/poor America comment I simply meant that if the higher valued properties always appreciated faster than the lower valued ones, then the gap between property values in the rich and poor sections of town would forever expand – wider and wider forever more.

    This is a topic I’ve kicked around with Jeff before, but I’ve always been too lazy to dig up the data to prove (or – possibly – disprove) the point one way or other. Maybe soon…

  9. Another Investor,

    “They are looking for properties they can turn over to a reasonably competent property manager and have the expectation of receiving a check almost every month.”

    Of course, finding that PM can be easier said than done! 🙂 I have vetted a few that pass the test!

    As far as wanting more cash flow, that is strictly your choice and while I don’t know much about your portfolio (we’ve never met, readers) it sounds like that you are more than experienced and have your goals clearly in mind. I also suspect you are not in your twenties or thirties anymore. That’s not a blast! by the way.

    And as far as your alligator comment newer readers need to know that means that your property just lies around, doesn’t produce anything but eats up your other assets. It’s not a good thing to have an alligator property.

    I try to avoid them like the plague! Or at least try. Because I’m brutal on expenses during the analysis phase.

  10. Christopher – I look forward to your findings. I would love to know the actual numbers.

  11. Guys — If relatively inferior areas appreciated in the long haul as well as superior areas, they wouldn’t be called inferior/superior for Heaven’s sake.

    I’ve been in markets all over California, Texas, Arizona, Idaho, Colorado and several others. Investors don’t go to the ‘lower’ type areas for a reason: They simply don’t perform as well. They’re either more management intensive, are more expensive to maintain, don’t appreciate as well, or all of the above.

    If that weren’t true, I’d be telling my clients something wholly different than I have been for the last three decades.

    Results is the only ‘factor’ that matters to an investor. And the relatively inferior areas of any region are perceived as inferior for empirical reasons — most of which add up to — inferior results for the investor.

    Perception based upon anything but empirical evidence is called theory. 🙂

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