Cash on cash return is the single most important number for a rental property investor to understand. It tells you what percentage return you are earning on the actual cash you put into a deal. Not the total property value, not the appreciation potential, just the return on your money that is sitting in the deal right now.
The formula is simple. Take your annual pre-tax cash flow and divide it by the total cash you invested. Multiply by 100 and you have your cash on cash return as a percentage.
Here is a real example. Say you buy a rental property for $120,000. You put 25% down which is $30,000. Your closing costs are $4,000 and you spend $6,000 on repairs to get it rent ready. Your total cash invested is $40,000.
The property rents for $1,200 per month. Your mortgage payment including taxes and insurance is $750. After setting aside 8% for maintenance and 6% for vacancy that is another $168 per month in reserves. Your monthly cash flow is $1,200 minus $750 minus $168 which equals $282 per month. Multiply by 12 and your annual cash flow is $3,384.
Now divide $3,384 by your $40,000 investment. That gives you 0.0846 or about 8.5% cash on cash return. That is a solid deal. Many investors target a minimum of 8% cash on cash return and consider anything above 10% to be strong.
You will hear a lot about cap rate in real estate investing circles. Cap rate has its place but for the individual investor who is financing properties, cash on cash return is a far more useful metric.
Cap rate ignores financing entirely. It assumes you paid all cash for the property. That is fine for comparing properties against each other on an apples to apples basis, but it does not tell you what your actual return is on the money you put in. Two properties with the same cap rate can have wildly different cash on cash returns depending on the interest rate, down payment, and loan terms.
Cash on cash return tells you exactly what your invested dollars are earning. If you can get 8% in a rental property but you could get 5% in a high yield savings account, you have a 3% premium for the work and risk of being a landlord. Is that enough? That is for you to decide, but at least you have the real number to make the decision with.
One thing to watch out for is that cash on cash return is a snapshot. It tells you what your return is right now based on current rent and current expenses. It does not account for appreciation, mortgage paydown, or tax benefits. A property with a 6% cash on cash return might actually be earning you 15% or more when you factor in equity buildup and depreciation.
On the flip side a property with a great cash on cash return in year one might look worse in year three when the roof needs replacing or property taxes get reassessed upward. This is why experienced investors look at cash on cash return as one tool in the toolbox, not the only tool. Run the number, make sure it is strong enough to justify the deal on cash flow alone, and then consider the other benefits as bonus upside.