Last time I brought you the cash flow formula. Now I bring you my other favourite indicator: cash on cash return.
Cash on cash return is a very important and often overlooked indicator when evaluating a real estate investment. It is well known that cash flow is the lifeblood of any business, and COCR measures the strength of that cash flow.
The main purpose of COCR is to identify how much cash you are putting into a project, and how much cash you are getting out. It is very efficient at measuring weather or not you are exceeding the opportunity cost of your money.
The formula is: Annual Cash Flow x 100 = Cash On Cash Return (expressed as a percentage)
Annual Cash Flow
Subtract all the monthly expenses from the monthly income to get the property's monthly cash flow. According to my rule, the cash flow must always be positive, and a minimum of $100 per month for a property to be worth your time and energy.
Having a cash flowing property insulates you from market fluctuations. As long as the property is producing positive cash flow the market can move up and down, and you can wait out the lows while still making money.
This includes the total cash infusion required to make the entire project profitable according to my cash flow rule above. Including, but not limited to, the following items:
•Down Payment - Generally per cent for a rental property in Canada;
•All closing costs - Legal fees, closing costs, etc.;
•Renovations required - An investor will often have to renovate an investment property before it is rented;
•Carrying cost until the property is rented.
Cash on Cash Return
Divide the annual cash flow by the cash invested and multiply by 100 to get the property's COCR index. According to my rule, the COCR index must always be a minimum of 3.5 for an investment property to be worth your time, and cover the opportunity cost of your cash investment.
Once you have prescreened a property to meet the cash flow criteria (minimum $100 per month), it is now time to visit the property and evaluate the COCR. I always visit the property before calculating the COCR because you never know what renovations are required until you physically show up.
Calculating and analyzing the COCR will bring the investor one step closer to finding that great investment property. It's important to note that a good property will satisfy both the positive cash flow rule and COCR rule.
With the old school banking rules it wasn't uncommon to put 5 per cent down on a property and get a COCR of over 10.0. Now that a new era of financing rules on rental properties has been ushered in, investors must turn more and more to indicators like COCR to maintain profitability and sustainable growth. These calculations are specific to the following terms: Financing at 4.5 per cent, 20 per cent down payment, 30 year amortization.
If the property passes both the cash flow rule and the COCR rule then it appears to be a solid investment property. Keep in mind there are other variables to consider before you proceed to purchase an investment property. Being pro-active, educating yourself, and properly analyzing the numbers are the keys to a successful career as a real estate investor.
Real estate entrepreneur Scott McGillivray is the host of HGTV's Income Property. hgtv.ca, scottmcgillivray.com. For more real estate investing information, visit TheSuccessfulLandlord.com. Want to be on HGTV's Income Property? Visit incomepropertytelevision.com for all the details.