By Don R Campbell
In order to become a true strategic investor we must, at least once per year, review our complete portfolio to uncover goldmines and identify underperforming assets. Once this analysis is complete we must then see if there are any strategic moves we need to make to maximize the Return-on-Investment we are receiving on our capital.
It sounds simple and, frankly, quite obvious. The reality is, though, many investors don’t complete this important exercise and even when they do they miss one critical analysis formula: The Cash-on-Cash PLUS Formula™.
The basic and most common Cash-on-Cash Return calculation produces a percentage figure based on the ratio between the amount of money invested in the property versus the amount of real cash-flow the property produces in a given year. However, if you only do that calculation, you are not able to make a clear comparison on how the property is performing overall within your portfolio NOR does it allow you to compare its performance against other investment options; which can lead to some disastrous investment decisions.
Get Real Analysis with Cash-on-Cash PLUS™
The Cash-on-Cash PLUS™ calculation, although more complex, gives you a more realistic and measurable look at your return-on-investment (ROI). It factors in the most important part of your investment, the mortgage pay down; a financial force that many mistakenly ignore. It is a forced savings that is paid for by someone else, your tenant; a forced savings that accelerates in year three as the principal pay down portion of your mortgage payment begins to get larger; a forced savings that builds you an extra financial buffer as the markets progress through their inevitable cycles.
This formula can be used both on your single-family residential homes as well as multi-family properties and even commercial and light industrial. Once you begin to use it on a regular basis, you make more strategic financing decisions, buying decisions, and you receive greater positive cash flow, whether the market goes up or not.
Here are the simple formulas required to calculate a true cash-on-cash scenario:
STEP #1 – Calculate the Cash Flow of the Property
When calculating the cash flow of the property, it is important to use real numbers (not estimates) wherever possible. This will include actual income collected, actual expense incurred and actual mortgage payments. The cash flow formula would look like this:
(Actual rental income collected + Actual laundry + other income)
minus actual operating expenses minus mortgage payment
= Cash Flow
STEP #2 – Calculate Cash-on-Cash Return part 1
This is the basic Cash-on-Cash calculation that many investors use, but it does not give you enough information to make a strategic decision. It will give you your actual return on your cash invested but not your real ROI. In this scenario, I suggest you include all costs to close on the property as well as capital you spend on the building in the first month as these would be obvious required repairs/upgrades. The cash flow formula would look like this:
Cash Flow / (Down payment + capital improvements + closing costs) x 100 = Cash-on-Cash return %
STEP #3 – Calculate Cash-on-Cash PLUS™ - Where the Magic OccursIn step 3, you discover what your real return on investment is from this property, even if the property value does not increase. The Cash-on-Cash PLUS™ calculation factors in your mortgage pay-down which occurs automatically with your mortgage payment. This is real equity that you collect upon the sale of your property.
The formula is a bit more complex than the basic Cash-on Cash calculation and you will need to do a little investigation to uncover what your actual mortgage pay down was over the previous 12 months. You can get this from your mortgage amortization schedule or your mortgage statement. You will note, in the Cash-on-Cash PLUS™ Formula, your expenses remain the same but now you are factoring in the forced mortgage pay down to the formula. Here’s how it looks:
(Cash Flow + annual mortgage pay-down) / (Down payment + capital improvements + closing costs) x 100 = Cash-on-Cash PLUS™
The Cash-on-Cash PLUS™ calculation is a return on investment calculation without having to worry about predicting what the market value of the property will do. If you are just buying as a pure market appreciation investment, then your cash-on-cash PLUS will look poor. This is really a formula designed for long-term buy-hold-rent strategies as well as current portfolio analysis.
The Cash-on-Cash PLUS™ calculation is a solid number based on real life results. It is also very helpful when dealing with bankers or Joint Venture partners, showing that you have a grasp on the investment strategy and can, in fact, show them how the property will perform even without any market appreciation. No hype, just real life numbers.
I suggest you become very familiar with this formula as it will be a valuable tool you can use even before you purchase your next property. It can help you decide how much to put down, how long to amortize the mortgage and even if it is worth accelerating or decelerating your mortgage pay down. You can also use the Cash-on-Cash PLUS™ formula to try out different investment scenarios.
To become a successful long term investors it pays to be strategic. By adopting this formula you will see exactly how to build and manage your growing portfolio.
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Don Campbell began his investing career in 1985 with a house purchased in Mission, BC. He is Founding Partner and Senior Analyst at The Real Estate Investment Network and currently owns nearly 200 doors in BC and Alberta. A seven-time best-selling author, Don’s expertise and passion for teaching Canadians how to create wealth through real estate are far-reaching and have made an impact on the lives of thousands. You can follow his daily thoughts on Twitter – www.twitter.com/DonRCampbell and on Facebook at www.facebook.com/thereinman.