What Is Cash-on-Cash Yield?
Cash-on-cash yield is a basic calculation used to estimate the return from an asset that generates income. Cash-on-cash yield also refers to the total amount of distributions paid annually by an income trust as a percentage of its current price. The cash-on-cash yield is a measurement technique that can be used to compare different unit trusts.
This term is also referred to as "cash-on-cash return."
- Cash-on-cash yield is used to calculate return from an asset that generates income. It is extensively used in valuations of commercial real estate calculations.
- It can be used to determine whether a property is overvalued or undervalued. But it is not a fully promised outlay.
- It cannot be completely relied on for accuracy because the metric may overstate yield if part of the distribution consists of return of capital instead of a return on capital.
Understanding Cash-on-Cash Yield
Cash-on-cash yield is useful as an initial estimate of the return from an investment and can be calculated as follows:
Cash-on-Cash Yield = Annual Net Cash Flow / Invested Equity
Cash-on-cash yield has number of limitations. The metric may overstate yield if part of the distribution consists of a "return of capital," rather than a "return on capital," as is often the case with income trusts. Also, as a pre-tax measure of return, it does not take taxes into consideration.
For example, if an apartment priced at $200,000 generates monthly rental income of $1,000, the cash-on-cash yield on an annualized basis would be: 6% ($1,000 * 12 / $200,000 = 0.06).
In the context of income trusts, assume a trust with a current market price of $20 pays out $2 in annual distributions, consisting of $1.50 in income and 50 cents in return of capital. The cash-on-cash yield in this case is 10%; however, since part of the distribution consists of return of capital, the actual yield is 7.5%. The cash-on-cash yield measure overstates the return in this case.
Cash-on-Cash Yield and Real Estate Value Calculations
While cash-on-cash yield can be used in a number of circumstances; the metric is often used in the real estate market when valuing commercial properties – particularly ones that involve long-term debt borrowing. Cash-on-cash yield can also be used when determining if a property is undervalued. When debt is noted in a real estate transaction (as is usually the case), the actual cash return of the investment differs from the standard return on investment (ROI).
Cash-on-cash yield does not include any appreciation or depreciation in the investment. Calculations based on standard ROI will incorporate the total return of an investment; on the other hand, cash-on-cash yield simply measures the return on the actual cash invested.
In contrast with a monthly coupon distribution, cash-on-cash yield is not a fully promised outlay. When forecasting, a cash-on-cash yield can only be used as an estimate to assess future potential.
Example of Cash-on-Cash Yield
Suppose a real estate company purchases a building for $500,000. It spends a further $100,000 on repairs to the building. To finance its purchase, the company makes a down payment of $100,000 and takes out a loan of $400,000 with yearly mortgage payments of $20,000. The company earns $50,000 in rental income during the first year.
The calculation for its cash-on-cash yield begins with cash flow. The cash flow for the company is $50,000 - $20,000 = $30,000. The total amount invested in the building is $220,000 = $100,000 (down payment) + $100,000 (repairs to the building) + $20,000 (mortgage payment). The building's cash-on-cash yield is 13.6% ($30,000 / $220,000).