Updated: Jan 9
For commercial real estate investors, syndicators and others involved in the field, investment terminology can appear to be an alphabet soup of mysterious acronyms. There are three in particular that are related to the return on real estate investments, and each has its own unique meaning and purpose.
They include CoC, which stands for Cash-on-Cash Return, IRR, which is an abbreviation for Internal Rate of Return, and Average Annual Return, which is self-explanatory. I’ll explore all three, and discuss the differences of each and how they apply when exploring real estate investments.
Cash-on-Cash Return is the simplest way to evaluate the performance of a real estate investment. It utilizes a formula to calculate the return on investment by taking the property’s annual net cash flow and divide by the investment’s down payment, and is expressed as a percentage. One important detail to keep in mind is that Cash-on-Cash Return doesn’t include the property’s appreciation or any principal debt payments. Appreciation is only taken into consideration when it is realized after the property is sold. It also doesn’t include principal debt payments.
Suppose you bought a property and your net cash flow was $5,000, and the cash invested in your property was $50,000. Using that example, your Cash-on-Cash return is 10% ($5,000/$50,000). The net property investment is usually the down payment - which is the property’s cost minus the amount you borrowed.
It’s a simple formula, but it’s critical to know how to calculate cash-on-cash return in order to be a successful investor. Just be sure it’s not the only measure you use to evaluate a potential real estate investment. Take a good look at factors like vacancy rates, operating expenses, debt service and any pre-rental improvements and repairs. All of those numbers will give you a good overview of the potential investment.
Cash-on-cash measures are best when evaluating a property’s first year performance, or when used to project a property’s first year performance that you’re considering buying. Here’s why: after 12 months the actual cash invested that you use in the formula to calculate the ROI will be changing as the loan is paid down, or when property improvements and repairs are made.
The main issue with CoC as a metric, is that it doesn’t take into consideration the time value of money; so if, for instance, you invested $1M in two deals and received $100,000 back (in addition to your initial investment), but in investment #1 you got the money back after 3 years while in investment #2 it took you 10 years to make the same profit – CoC will still be identical, even though it’s clear that investment #1 is better.
As a metric for a potential investment, you’re probably wondering what a “good:” cash-on-cash return would be. The problem is that the experts in the real estate investment field disagree on what constitutes a “good” CoC investment. Some look at a return of 6-8% as “good” while other experts would expect a CoC return of 10% or more. The bottom line is that “good” is subjective and is based on your willingness to take risks.