After you started investing in the stock market for a while, you are probably thinking about diversifying beyond stocks, bonds, and REITs. A common next step for many investors is investing in a rental property. Personally, that is what I did, and as a fairly seasoned real estate investor, I feel that it is important to find a rental property with positive cash flow and a return on investment (ROI) that is comparable or better than the stock market. After all, you are going to be doing more work for the money.
Cash on Cash Return (CCR) vs Return on Investment (ROI)
Before we dig deeper, what exactly is the difference between cash on cash return (CCR) and return on investment (ROI)?
Cash on cash return (CCR) is a measure of how much cash an investment generates relative to the money invested over a period of time.
For example, if you invested $10,000 in a high-yield savings account with a 1.75% APY and you have $10,175 at the end of a year, then the CCR is 1.75%.
Return on investment (ROI) measures the total wealth generated relative to the money invested over a period of time.
For example, if you invested $10,000 in a portfolio of dividend stocks and your portfolio grew from $10,000 to $15,000, plus you received $500 in dividend payments, then your CCR is 5% (i.e., $500 ÷ $10,000) and your ROI is 55% (i.e., $5,500 ÷ $10,000)
What about a rental property? For a rental property,
CCR = Annual Cash Flow ÷ Initial Investment
For example, a property that generates $4,000 in cash flow that you spent $40,000 to acquire has a CCR of 10%. CCR is a measure of stability. When you have a positive cash flow and higher CCR, your rental property is self-sustaining. You don’t have to dig into your savings to cover the repairs and vacancies.
The ROI calculation is a little more complicated since it takes into account (1) the yearly tax benefits, (2) appreciation in the property value, and (3) the amount that you paid down on your mortgage.
Calculating Cash on Cash Return
Let’s take a look at a real-life example. This is a rental property that I acquired in 2012.
Cash flow is fairly low which typical for the area that I am in, and we also did several major improvements to the property which increased the repairs category quite a bit.
Calculating Return on Investment
Now, looking at the same property from the ROI perspective. We owned this property for almost 8 years now.
- A. Initial Investment = $48,699
- B. Total Cash Flow = $12,512
- C. Total Principal Reduction = $41,090
- D. Total Appreciation = $49,695 (we factored in the approximate costs of selling in this amount)
- E. Total Wealth Generated = B + C + D = $103,297 (or about $12,944 per year)
- ROI = E ÷ A = $12,944 ÷ $48,699 = 26.6%
Do You Have a Good CCR and ROI?
To determine if you have a good investment, we usually compare it to the most popular benchmark, aka, the S&P 500. For this investment property, the CCR of 3.21% is better than the average yield of the S&P 500 of about 2%. The ROI of 26.6% is excellent compared to the S&P 500 Index, which returns about 9% a year.
One reason why a good rental property can pull off this huge ROI is what we call LEVERAGE. For example, to get the average 9% ROI from the stock market, you need to invest 100% of your money. In real estate, you can buy a $250,000 house with $50,000 (i.e., 20% down payment). When that house appreciates $40,000, you’re getting 80% ROI ($40,000 gain ÷ $50,000 investment) — because you only put down 20%, you effectively have a 5x leverage on the appreciation.
Here is a good video from the BiggerPockets that discusses the difference between “Cash on Cash Return” and “Return on Investment”
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.
More fortunes have been built in real-estate than in any other asset class because of that leverage that you mention. The main reason why most people invest in stocks rather than real-estate? It’s easier!
I MAKE my money in this descending order: 1. Businesses; 2. Real-estate; 3. Stocks
I KEEP my money in this order: 1. Cash (only in current market); 2. Real-Estate; 3. Stocks.
The costs and other factors you mentioned in your post are exactly why my only residential real estate investment is my home. I don’t have the time or patience for that. This is why I invest in highly researched land in the path of growth in Southern California. No headaches…you just pay your taxes, which are very inexpensive. You wait for about 10 years and get your offers from developers and consolidators. Then the company I invest with negotiates with them free of charge for the highest and best price at market readiness. They’re amazing! I enjoy this type of… Read more »
Thanks for the links!
I really prefer to invest in stocks, ETFs and REITs – one big factor that people never quantify is the time they spend looking after their rentals.
Excellent article! I like to use rehab loans for my house flips. I even use this type of loan for my rental properties. It’s a zero down loan and if I sell within a year I can get the same types of returns as you mention in your article. If I decide to keep it, I usually have to pay closing costs to convert it after a year. Oh and the other thing is that I’m making interest only payments during the rehab period. If I’m done to two months, I still have 10 months interest only and renting during… Read more »
@Kelly – It’s great that you found something that works for you.
@Four Pillars – I agree, time is a big factor.
@Vernon – Thank you for sharing your technique with us. I am not that advanced yet, but it’s interesting.
You’re forgetting a very important part about leverage — risk. Leverage goes both ways.
If, after 10 years, the stock and house are both worth 95K, then you’ve lost 5% of your stock investment and 100% of your real estate investment.
Granted, 10 years is a long horizon for something to go down.
Don’t forget leverage can work against you as well. Losing on investment means you lost on your equity and debt as well and you still have to repay the debt. I wrote a post on the matter as well
There is no free money. If real estate was such a great investment with returns better than 1000%, then everyone would be doing it to the exclusion of all other investments. In a free market, the returns would then decrease to a satisfactory risk adjusted basis. Don’t get me wrong, real estate is a good investment and a great diversification play. However, the typical REIT (Real Estate Investment Trust) is expected to return 7% to 9% a year and these guys are well capitalized, well connected pros. I have had some fortunate experiences investing in commercial real estate and write… Read more »
I have a rental property, the tenants damaged it, it’s vacant for a long time now and looking to sell it but the buyer, who is an investor is bidding at a very low price (way below the money I owe the bank)… I may have to bring $14,000 to the table to sell the house..
@Dorian — Yes. And they are usually more painful too.
@Terry — Excellent point!
@Ty — I am sorry about your situation, however, I cannot offer you any advice.