People who buy investment properties often talk about return on investment (ROI) and cash on cash return (CCR). Some mistakenly use the terms interchangeably. Both figures are important, so you need to know how to calculate them. Then you need to know what they mean when considered together.
Let's clear up the confusion.
Return on investment can be simple to understand. It is probably the figure most familiar to people who buy real estate.
Here is how it works. If you buy a property for $100,000 and it appreciates to $150,000 a year later, here is what you made.
150,000 - 100,000 = 50% ROI
You made 50% on your original investment of $100,000. (Let's leave out expenses for this example.)
So far, so good. This is the kind of figure you want if you are investing for appreciation.
However, few people pay cash for a property. If you only put 10% down on the same property, then you invested only $10,000. Now you sell the property for $150,000, making $50,000 more than the house was originally worth. Subtract your initial cash down payment, and you made $40,000 on a $10,000 investment. Your ROI is 400%.
(The above example leaves out any mortgage payments you made. This makes the example easier to understand.)
Cash on cash return is most often used to measure the amount of annual cash income you receive based on your initial investment. For example, if you buy a property for $100,000 and collect rents worth $24,000 total for the year, your annual CCR is 24%.
But again, few pay cash for a property. If you put down 10%, or $10,000, and made the same $24,000 from rents, you made $14,000 in profit. So you made 140% CCR on your original down payment. We arrive at this figure by subtracting your down payment from the income and dividing by the down payment. So $24,000 income - $10,000 down payment = $14,000 profit. $14,000 divided by $10,000 = 140%.
Your cash-on-cash return for the year is 140%.
ROI plus CCR
The calculations really get interesting when you combine the property appreciation with the cash income it produces. To keep it simple, we will say you only keep the property for one year.
So, you put $10,000 down on a $100,000 property. You make $24,000 from rents for the year. You also make $50,000 when you sell it. You made $74,000 on the deal, and only invested $10,000. That means a $64,000 profit. That means you made 640% on your investment.
Here's how we calculate: $74,000 profit - $10,000 down payment = $64,000. Divide $64,000 by your down payment of $10,000 and you get 640%.
The Real World
The examples are cleaned up to avoid getting too complicated. In reality, you would be making payments on the mortgage all year long, and you would have to add those payments to your cash investment total.
And of course, you would have expenses, from taxes to fees. These would have to be subtracted from your profit.
So, your $74,000 gross profit might not count $14,000 in fees and expenses. Now your profit is $60,000.
In addition, you made monthly payments totaling $12,000 for the year. That must be added to your initial down payment of $10,000, so your cash investment was $22,000. Now $60,000 -$22,000 means you actually made $38,000. Divide $38,000 profit by the $22,000 investment, and you made 172%.
The Bottom Line
You should always estimate your ROI and your CCR before investing in a property. As you can see, the numbers can be pretty exciting when you leave out taxes, expenses, and monthly payments. A realistic evaluation, based on some solid expectations, will give you a much more down-to-earth idea of how much you can make on a property.
Notice that the example used a large appreciation number. You most likely wouldn't get that much in a year. Also, note that you have to add up all the years if you hold the property for a long time. There can be bad years, and there can be exceptional years. The best practice is to recalculate RIO and CCR as your hold property over many years, so you will know if it is still valuable for you.