Sunday, August 1, 2010

Cash-on-Cash Management for a rental property

When determining the attractiveness of a real estate investment there are various measuring sticks one can use. In past posts, we often talk about ‘Positive Cash Flow’, which is the same as remaining cash from a rental operation after paying all expenses including the mortgage payments.

When looking at a real estate income statement, sometimes referred to as APOD (Annual Property Operating Statement) it comprises several components:
          1. Effective Rent (Gross Rent minus Incentives minus Vacancy Charge)
          2. Operating Costs (Property taxes, Utilities (when paid by landlord), Maintenance/replacement, Condo fees, Management fees, etc.)
          3. Net Operating Income (NOI) = Effective Rent minus Operating Costs.

Capitalization Ratio (Cap Rate) is NOI divided by the Purchase Price.

To Arrive at Net Cash Flow, one deducts from the Net Operating Income the Debt Service Costs (both Interest and Principal Repayment). For a landlord to be able to keep a property in ‘perpetuity’ the Net Cash Flow should be positive – i.e. the property is self-sustaining.

When buying stock, we often compare Net Operating Income with Dividend. If the stock investment is purchased with borrowed funds, Net Cash Flow would be the Dividend minus the Debt Service.
For some investors, receiving positive cash flow is important; this is what they often live off when ‘retired’. Thus, they want to know what the Cash-on-cash return is. This can be simply expressed as the ratio of Net Cash Flow divided by the cash they have sunk into the investment –  in real estate this is typically the down payment (d= equity/purchase pirce. Note, 'd' is the counter part of LTV (loan to Valio ratio).

Cash-on-cash return (CoC) can be bolstered or diminished by the amount of leverage being used (d = 1-LTV) and the mortgage rate. When the Cap rate (CAP) is less than the interest rate paid on the mortgage, Net Cash Flow will go down (i.e. it is negatively leveraged). When the Mortgage rate (i) is less than the cap rate, the Net Cash Flow is enhanced (i.e. it is positively leveraged). On the REIN forum, an equation was published that expresses the relationship between Cash-on-cash return, the mortgage rate and the amount of leverage applied. The equation is as follows:

CoC = {(CAP-i)/d}+i

I used this equation to create the graph below on EXCEL. The graph illustrates some important issues related to Cash-on-Cash return, mortgage rate and leverage. With increased leverage the Cash-on-Cash return does go up, but not in a linear fashion. It increases exponentially!

Using a cap rate of 4.5% (pretty high for Calgary) and a (variable) mortgage rate starting at 2%, I graphed the Cash-on-Cash return for various down payment/purchase price ratios (d=1-LTV). The following was observed:

First, when using a high LTV (95%) you will need a lot of properties in your portfolio to have a significant impact on the overall performance. Say you have $100,000 and your Cash-on-cash return is a very attractive 20% with a LTV of 95%, you would need to own ten $200,000-properties to earn 20% on your entire portfolio. That is a lot of work, hassle and risk (leverage).

Secondly, if your (variable) mortgage rate increases from 2% to 3% (on the graph that is 'plus 1%’), your Cash-on-Cash return (COC) goes down significantly. When the rate increases further, you may get even a negative CoC (and not just a little bit). If the mortgage rate goes from 2% up to 6% ('Plus 4%'), at a 95% LTV you suddenly have a negative COC of 24% and at a rate of 7% the CoC goes down to -43%,

Thus, if apart from an overall good return on investment (ROI), the amount of cash you can draw from a property is important, Cash-on-Cash management is important. This little exercise shows how Cash-on-Cash management is significantly impacted by the amount of leverage, the mortgage rate and Net Operating Income as expressed by the Cap Rate.

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