If you missed part 2 of this series I explained that Cash Flow is defined as all of a property’s cash inflows minus all of its cash outflows during a given period of time. But as a calculation used to analyze real estate it shouldn’t sit on an island all by itself. There are several other formulas that when paired with Cash Flow can help you make stronger investment decisions. Two of those formulas are:
1. Cash-on-Cash return: This is defined as the ratio between a property’s Cash Flow in a particular year and the amount of initial capital invested. This formula allows you to compare your real estate Cash Flow to any other investment. For example: If you invest in a rental property that cashflows $500/month or $6k/yr and you initially invested $50k into the property. Your Cash-on-Cash Return would be 12%. Take that 12% return and compare it to a bank Certificate of Deposit that offers you a .005% return over 12 months. To achieve the same $6k return you would need to invest $1.2M into that Certificate of Deposit. It’s a no brainer that one opportunity outweighs the other.
2. Return on Equity: This is defined as the ratio between a property’s Cash Flow and it’s equity. Equity defined as the current value of the property minus the mortgage balance or anything else owed against the property. This formula allows you to know when Cash Flow is being left on the table. For example, let’s say you have that same property that you put $50k into for that 12% cash on cash return. Over time as the initial equity of $50k grows into lets say $75k through (1) loan paydown and (2) appreciation, the same Cash Flow of $6,000/yr now becomes an 8% annual return on your equity.
As you can see, over time even the best cash flowing deals can become average cash flowing deals at no fault to you as the owner. And that’s why it’s in your best interest as a property owner to keep track of your return on equity.
With the understanding of these 2 additional formulas paired with understanding Cash Flow, you can analyze your current portfolio and also potential deals with the confidence that you can make educated decisions.
Tune into part 3 where I’ll share a real life case study where I was able to help a Capital Street Management owner client put these formulas to use. By using both formulas they were able to analyze their portfolio and made a decision that would lead to higher returns and more Cash Flow. I’m Albert with Capital Street Management. Thanks for reading this post.
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