Cash on Cash Return vs. Internal Rate of Return
Cash on Cash
Cash in Cash return, or Return on Investment (ROI) is the easiest Rate of return to calculate. It is also the one I use the most often as it tells me what the money is generating with regard to actual cash I can put in my pocket today.
To calculate it you take the amount you are getting from an investment, typically on an annual basis, and divide it by the amount you have invested. Multiply this number By 100 and you have a percentage representing Cash on Cash Return.
For example if I have $10,000 in a property that is netting $100 per month, I am getting $1200 per year on my $10,000.
I divide the $1200 by $10,000 to get .12 I multiply this number by 100 to get my percentage of 12%
As you can see, cash on cash is a pretty simple and straightforward calculation. But what if we want to take into account the amount we are paying down on the loan each month, or he appreciation of the property?
Internal Rate of Return
Internal rate of return (Sometimes called Annual percentage yield) is the total true return on an investment taking into account depreciation, appreciation, and equity gained from paying down the debt.
It is much harder to calculate, as items such as depreciation depend on your taxable income. You also have to make some assumptions with regard to appreciation until a property is actually sold and that number is known.
This calculation is typically done over a holding period of 3 to 7 years. The period is usually fairly short since IRR typically decreases as time goes on.
If we take the example above assuming the following:
1) Home is worth $100,000.
2) I can depreciate 3% of its value the first year,
3) I am in a 35% tax bracket.
4) That property values have appreciates at 6% that year
5) I am paying down $100 per month toward the principal on my mortgage payment.
We get the following:
$1200 Cash on Cash return from above
$1050 Depreciation ($3000 Depreciation X 35% tax bracket)
$6000 Appreciation ($100,000 X 7%)
$1200 Principal Pay Down ($100 X 12 Months)
$9,450 Total Internal Return
As a percentage:
$9450 first year IR divided by $10,000 initial investment = 94.5% IRR the first year.
Keep in mind that this is not spendable cash. Appreciation was our biggest number and it won’t be realized until we sell the home.
I have found that if I am doing well with regard to cash on cash return, my IRR Is going to be a better number. This assumes that there are no deferred maintenance issues and that I am not going to sell the property at a loss.