[New post] Cash On Cash ROI Leverage: Seductive But Risky!

The Cash on cash ROI metric reveals the full power of leverage in profitable investments. But watch out! Cash on cash ROI turns a blind eye to the risks.

One Investment, Three Different ROIs

Cash on cash ROI is a favorite metric of real estate investors who make short term investments with temporary use of long term loans.

Investing with leverage simply means investing with borrowed funds. Leverage can pay off handsomely when these funds earn more than the cost of borrowing. A favorite metric of those who make capital investments, cash on cash ROI, shows just how attractive the payoff can be.

Consider for example, a property purchase for $1,000,000 on 1 January. One year later, the investor sells it for $1,200,000. What is the investor's profit? In other words, what is the investor's Return on Investment ROI?

In fact, those making such transactions may answer with three different ROI metrics. As a result, there are three valid ROI conclusions for this example:

Some investors look at these results and say: Thank you very much! I'll go with number 3, the cash on cash result!

What's wrong with this picture? Does cash on cash ROI show real profitability? Or, does cash on cash ROI instead use some kind of sleight-of-hand to hide realities?

In brief, the message from the cash on cash result is perfectly valid. But, compared to simple ROI, cash on cash ROI requires extra assumptions that may or may not stand up during investment life. And, for this reason, the cash on cash ROI comes with greater risk and greater uncertainty.

To understand the role of these assumptions therefore, consider briefly how these three ROIs result from the example data.

For more in-depth coverage of cash on cash ROI, please see Cash on Cash ROI. For complete coverage of Simple ROI in cash flow analysis, see Return on Investment.

1. First Pass Simple ROI

First-pass simple ROI results entirely from the purchase price and selling price above:

Simple ROI = (Investment Gains – Investment Cost) / (Investment cost)
= (1,200,000 – 1,000,000) / (1,000,000)
= 20.0%

2. Cost-Accurate Simple ROI

First pass simple ROI does not include all investment costs. This means that the investor incurs costs besides the original purchase price while owning the property. Consider therefore ROI again, but with these additional investor costs:

$2,400 Loan origination and loan closing fees
$9,600 Insurance and maintenance costs
$48,000 Twelve monthly loan payments ($38,000 interest + $10,000 principal)

These additional Year-1 costs total $60,000

Therefore:
Cost-Accurate ROI = (Total Gains – Total Investment Costs) / (Total costs)
= (1,200,000 – (1,000,000 + 60,000 ) / (1,060,000)
= 13.2%

3. Cash On Cash ROI

Cash on cash ROI considers only actual pre-tax cash inflows received and outflows paid by the investor during investment life. As a result, cash on cash ROI calls for extra assumptions. To see how this works, assume the following:

The cash on cash ROI is therefore:

Cash on Cash ROI = (Total cash gains – Total cash costs) / Total cash costs
Cash on cash ROI = ($410,000 – $260,000) / $260,000
= 57.7%

What is return on capital? What is cash on cash ROI?

The term cash on cash refers to a special form of return on investment analysis (ROI) restricted to the pre-tax cash portions (or capital portions) of larger investments.

Business people sometimes use the term return on capital. This refers to a similar ROI approach for investments or costly actions, where investment costs are partially borne by the investing company with its own capital, while the remaining costs are covered through loans, grants, tax incentives, or some other kind of external funding. Return on capital ROI therefore has the same meaning as cash on cash ROI.

In such cases, return on capital ROI (just like cash on cash ROI) also shows directly the return on the investor's own investment funds.

Cash on Cash ROI calls for Serious Risk Analysis

Many investors in the real world do make purchase decisions relying on cash on cash ROI. Note especially, however, that while none of the above ROI figures by itself considers investment risks, cash on cash ROI brings the greatest risks:

Betting on cash on cash ROI, in other words, seems like a real gamble. Losing the bet can mean a substantial loss, or as many learn, bankruptcy.

The investor's best bet in such cases is a serious risk and sensitivity analysis for all 3 ROI metrics in view.
Consequently, the investor who does perform these analyses, will find the cash on cash ROI metric to be the most useful for showing:

Where to Go From Here

For more on:

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By Marty Schmidt. Copyright © 2004-2016.
Solution Matrix Limited, Publisher
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