I’ve been wanting to dive deep into better understanding the world of real estate investing taking a more analytical approach.

Here in Spain, despite the housing crisis that we are going through, real estate or “el ladrillo 🧱” as we call it, remains the number one asset and generally the most popular of all when it comes to parking our money. It is ingrained in our common imagination and shared culture to first and foremost invest in bricks that we can touch and sort of dismiss other alternatives like the stock market, perfectly illustrated in our common phrase “jugar en bolsa” (the use of the word jugar -> play in the stock market, as opposed to invertir -> invest). This is slowly changing over time but still very present.

So despite being by far the number one asset in my country, it feels like I learned about looking for a property paying way more attention to qualitative factors and neglecting cold, hard numbers to be able to analyze whether a property is worth investing in. Taking the emotion out of the picture.

I’ve previously written about how is your fixed mortgage calculated, and over the holidays I have been reading about real estate investment and the metrics that are in play, and as usual, to solidify my knowledge I want to make a series of blog posts to help me get back to them when I inevitably forget what they mean and how they work, and hopefully they are useful to you as well.

Cash on Cash

This metrics answers the question “How hard is the total cash I invested working for me now, accounting for leverage”.

Accounting for leverage means that it always assumes you have gotten a mortgage for the house, so it measures the annual cash flow generated by the property relative to the total amount of cash invested at the beginning, sort of like a dividend yield but for real estate.

I mention the “dividend-yield” general idea because when you focus on cash-on-cash you’re not taking into account the property appreciation, only the percentage return on the total amount of money you’ve put at the beginning.

The formula for cash-on-cash is:

And so the Annual Cash Flow is calculated as is:

The Annual Rent - Operating Expenses is another metric on itself called Net Operating Income (NOI) that I will write about in detail in another post, but the general idea is that you want to understand the cash flow split in two blocks:

• One block, the NOI, tells you how much is the property earning per year by taking the total annual rent and subtracting the unavoidable expenses that come along with it (maintenance, home owners association fees, insurance, etc..), regardless of whether you have a mortgage or not.
• The other block, the Annual Debt Service, is the amount you’ll be paying to cover your debt for the mortgage.

So the total cash flow accounting for leverage, is as said before, the NOI - Annual Debt Service.

As for the Total Cash Invested, it obviously accounts for the down payment, but also for the closing costs, and initial repairs you might need to get the property up & running.

In a more concrete example with round numbers:

Say you want to buy a €100,000 house (good luck finding that in my hometown), and you have what is normally the minimum downpayment to get a mortage in Spain, 20% -> €20,000. The ITP (Impuesto de transmisiones patrimonales), or “closing costs” is 8% in my region so:

• Purchase price: €100,000
• Down payment: 20% → €20,000
• Closing costs: 100,000 * 0.08 = €8000

Total cash invested: €28000.

I am not going to go about calculating the annual debt service here, I refer you to this post for that, so let’s assume our total cash flow is €6000.

Cash on Cash = 6000/28000 = 0.21428571428 ≈ 21.4%.

This is why Cash-on-Cash is so attractive: it often looks very high compared to stock dividends or bonds.

Comparing with other metrics:

Cash-on-Cash vs Cap Rate

There’s this other metric, Cap Rate, that has a very similar formula to Cash-on-Cash:

The way I see it, is that Cap Rate = Cash-on-Cash without a mortage. Assuming you pay for the property all-cash, means you don’t have a debt, so the annual debt service is not existing, and the total cash invested = property price.

This way, for the Cap Rate you have a metric to compare the performance of two different properties regardless of your financing, and with Cash-on-Cash you can evaluate how strong is your return going to be assuming your financing capabilities.

This is very personal, as a retail investor might not get low interest rates and also might be forced to provide way higher downpayments than an institution because they cannot access the deal volume of an institution to have negotiating power.

Cash-on-Cash vs Debt Service Coverage Ratio (DSCR)

DSCR gives you a ratio to compare whether your debt is covered by the net operating income.

If you only care about cash, anything below 1 is a no-go.

Having 1 would mean your NOI (income) covers exactly the mortage, so if you’re looking for cash returns what’s the point.

It could make sense if you think that despite the property not generating any cash flow, you will get the return back in the property’s appreciation, but for a retail investor it feels very dangerous to be exposed to unforeseen vacancies or excessive operating costs that will put you in the red.

Cash-on-Cash vs Internal Rate of Return (IRR)

The internal rate of return answers the question: “On average, how fast did my money grow each year, considering when I added money and when I got it back?”. It is the application of the Discounted Cash Flow formula to a real estate investment.

Basically it tells you what yearly return you are getting on a given time horizon, accounting for your initial investment, the cash flows, and the eventual sale of the property.

Cash-on-Cash measures the annual return of your cash, while IRR measures the total return of your investment in a given time horizon.

This means that you can have low Cash-on-Cash but eventually you make a sale for a huge multiple and IRR is over the top. Kind of makes sense for institutional investors where they might not have an immediate need for cash flow and they can wait for the property to appreciate for a long time. Conversely, you can have a high Cash-on-Cash but now your money is tied up for a long time and the property does not appreciate that much, yielding a poor IRR overall.

Cash-on-Cash strategies

I can only imagine that this metric is the go-to for retail investors, where you get to see the immediate return of your investment per year, allowing you to compare how well an investment might go with different mortgage conditions, or compare different properties with different mortgages and see the one that best adjusts to the return you expect.

Have fun!