We’ve all been there: a fresh faced intern running coffee, replacing #56 ink cartridges (or #57? Argh), making sure the perfectionist, power hungry boss’s pencils are perfectly sharp (Today’s a big day!). True story: a former boss of mine needed 20+ No. 2 pencils freshly sharpened every morning. My suggestion was mechanical pencils; my punishment was loosely tied to heretics.
And if that’s bad, screw up his Venti Orange Mocha Frappuccino – a drink with a majority of incomprehensible words. My strong points are not menial tasks.
But interning has its place, right? Busy work in exchange for experience and knowledge… sponging the attributes of a boss who has already galloped the gauntlet. What an invaluable resource… that is, until you’re told questions are forbidden and Google has all the answers. Well, for that, I thank all undeserving bosses! Your incompetence has led us to a golden land, the land of Google.
So like any inquisitive intern, I turned to my mentor Google and searched Cash on Cash… and what a finding! Besides Cap Rate, Cash on Cash is the next most important indicator of value in commercial real estate.
Cash on Cash is the ratio of cash earned to the total amount of cash invested, expressed as a percentage. Typically Cash on Cash applies to investments where financing is included.
You might be thinking: wait a minute oh wise financial intern, that sounds a lot like Cap Rate! And you’d be right, it does! But if my internship taught me anything, a mentor doesn’t make anything easy, so I propose an evolved geometric riddle:
Riddle: How can a Cap Rate be Cash on Cash, but Cash on Cash not a Cap Rate?
Before you answer, review the chart below, you might find yourself a helpful hint…
Answer: For the same reason a square is a rectangle, but a rectangle isn’t necessarily a square! Gosh, I love riddles.
If an investment is purchased all cash, the purchase price is the down payment, and your NOI is the same as your cash flow; you have no debt service. A no-financing investment is an unleveraged investment, making it possible to consider Cap Rate an unleveraged Cash on Cash (the square rectangle!)
However, when financing is included, the down payment is not the purchase price and the cash flow is not your NOI. The loan comprises a portion of the purchase price, and the cost of debt service must be deducted from your NOI.
As the Cap Rate remains constant for both scenarios (the rectangular square!), the Cash on Cash ratio changes based on the terms and costs of the loan.
So if an investor chooses to leverage, he can get into a property for significantly less capital, but his penalty is making loan payments, which is captured in the loss of cash in the Cash on Cash ratio!
To help you understand this concept further, download our FREE Cash on Cash Matrix and Calculator!