Cash on cash return

This article has been posted in 'MY-RealProperty2'

Q.
How to calculate cash flow in a property investment? What is cash on cash return?

A.
What is cash flow? As understood in accounting, cash flow denotes cash movement in an activity of business venture.

For example, an investment of house for rental income demands a outlay of RM30,000 and an income of monthly rental of RM1,000, the cash flow for annual cash on cash return is:

RM1,000 x 12 / RM30,000 x 100% = 12,000/30,000 x 100% = 40%.

Of course, the outlay of RM30,000 is a straight forward example. On the other hand, it can be as complicated as interest to bank of 4.25% on a loan taken as 90% of the purchase price or a house at RM245,000 over 25 years, with monthly installment of RM1,195.00.

In such case, the 10% down payment is RM24,500 and other costs like legal fees and stamp duties that build up to RM30,000 is RM5,500. To complicate the matter more, there is maintenance charges monthly at RM110. So, how to calculate the Annual Cash On Cash Return?

Initial outlay (first year) would be:

RM24,500 + RM5,500 + RM1,195 x 12 + RM110 x 12 = RM45,660. (Cash out flow)

Income from collection of Rental:

RM1,000 x 12 = RM12,000. (Cash in flow)

Cash on cash Return on first year = 12,000 / 45,660 x 100% = 26.3%

Cash on cash Return on second year = 12,000 / (1195 x 12 + 110 x 12) x 100% = 12,000 / 15,660 x 100% = 76.6%

Hence, cash on cash return has increased on second year. However, you would probably disagree with this calculation as a method of assessing return. Why? It is not realistic as the property has not changed, but the return almost tripled! (76.6% / 26.3% = 2.9 times)

Therefore, a more fair reflection should be cash flow.

Year 1: total cash outwards = 45,660 vs total cash inwards 12,000; net cash flow (33,660)

Year 2: total cash outwards = 15,660 vs total cash inwards 12,000; net cash flow (3,660)

Which is, still not a true reflection, but it is showing a more realistic figures of negative cash flow of RM3,660 per year. This means the investment is not earning income, and hence a failing investment. It would bleed through time, and unless there is a chance to increase the rental, the holding of this property in fact is not profitable.

Then again, you may argue that there is capital gain over time. This means the property will appreciate over time, and the appreciation gain would compensate the outflow of cash, RM3,660 annually.

This being so, is partly true as on an average, property would appreciate at 10% yearly. So, we can estimate an yearly appreciation of RM24,500 on the value of the house. However, as there is no cash flow (as there had to be property sold to realize the gain), cash flow analysis does not take that into consideration.

The other factors that need to be considered is the interest paid on the loan. Initially, the interest paid would probably be 80% of the total installment, at RM956 x 12 = RM11,472. Thus, the RM24,500 gain would have to deduct out this interest paid to the bank, leaving RM13,028. Taking away the RM1,320 in maintenance charges, it remains at RM11,708.

Hence, the investment is still a positive one, with the rental of RM12,000 = RM23,708.

It is this capital gain which makes investing in property a viable venture. After all, if you put RM30,000 in the bank or Amanah Saham, how much a year fixed deposit would yield? RM30,000 x 6% = RM1,800.