The Fallacy of Depending on Cash On Cash Returns

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

10% 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.

Reprinted from BBQ Capital: Kansas City Real Estate Investing  with permission.  All rights reserved.