Perhaps the most distinct and unappreciated difference between commercial real estate and other asset investments is the role cash flow plays in the value proposition of a property investment. That’s why, in addition to typical performance calculations, commercial real estate investors must pay close attention to one crucial variable: cash flow.
Understanding how cash is being spent and generated within a property is necessary because, while return on investment (ROI) estimates show the net value on a piece of property, this metric often fails to accurately illustrate how an investor’s cash is anticipated to grow over the lifecycle of an investment.
In addition to the positive cash flow from renting out units as apartments or offices, commercial real estate investments also generally involve outflow to pay back borrowed capital. Furthermore, since commercial real estate investors ultimately aim to exit their position in a property, the final sale price often obscures the value of the income generated from the property’s day-to-day operations.
As a result, while ROI calculations or capitalization rates serve as helpful barometers for investment performance, it’s necessary to look more closely at annual fluctuations in cash flow in order to capitalize on the passive income-generating opportunities that commercial real estate investments can offer.
When it comes to commercial real estate, the best way to measure cash flow is Cash-on-Cash return (CoC). In essence, an investment’s CoC return equals the annual pre-cash tax flow divided by the total amount of cash invested.
The reason understanding CoC is critical when weighing commercial real estate investments is because commercial projects generally entail a considerable volume of cash flow, both in and out of the property, with investments offering annual distributions. And unlike ROI, an investment’s CoC return shows exactly how much an investor’s cash investment will return annually, as opposed to the overall rate of return on the investment vehicle. Put another way, the difference between ROI and CoC is analogous to the difference between knowing how far a full tank of gas will get you versus knowing how far you’ll get with the remaining gas currently in your tank.
Since every property is unique, understanding how yearly expenses impact the property’s core business will better illustrate the risk/reward profile of the investment over time compared to simply projecting the end yield. This is particularly true for Class B and C assets, which stand to benefit the most from renovations and tend to see higher cash-flow earlier in the investment compared to Class A properties that generally carry more modest value add. In many cases, the annual CoC rates for Class A buildings will push most of the returns to the final year of the deal when the added equity value has had time to appear in the building revenue, while CoC rates on Class B and C properties are generally frontloaded as the investment improves the property and attracts new leases and higher-income tenants.
As a result, while CoC and return metrics like ROI should both play a role in evaluating the lifetime performance of these types of investments, CoC returns better reflect how your invested capital is performing in the moment, and can therefore provide invaluable insight into potentially undervalued investments that stand to reap the highest return from renovations and improvements.
Say you purchased a multifamily housing unit for $1.4M with a $700K mortgage. You expect your annual rental income for the whole property to be $15K a month, which puts the annual return on the property at $180K.
If you were calculating the ROI of the investment, you would simply take the annual return of $180K and divide that by the total amount invested in the property, if we assume the property did not appreciate in value after you bought it. That gives you an annual ROI of 12.8%. Not bad.
However, when calculating the CoC, the focus is less on the total capital involved and more on how much cash you end up with each year as a result of your investment.
In this case, you would deduct the $700K worth of debt used to buy the property from the initial investment while also subtracting mortgage payments and the cost of any maintenance or repairs from your annual return in order to arrive at your annual cash flow. Let’s say you end up spending $130K in the first year. This leaves you with an annual net cash flow of $50K. Dividing this by the cash you invested to buy the property leaves you with an annual CoC of a little over 7%.
The thing is, the CoC rate will fluctuate over time depending on the inflows and outflows of cash from the property. Maybe you spend a year improving the property and you raise the rent, which ends up boosting your rate to 10% the following year. Or perhaps you simply pay down the mortgage and sell the property for $1.6M a few years later. In that case, your average annual CoC could end up being 18% or more, depending on your timeframe and how much debt you paid off.
The bottom line is, the inflow and outflow of cash from a property often paints a more realistic picture of the true value of your investment over time, as opposed to just focusing on the final figure.
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