Most serious musicians eventually have to learn music theory. Like studying grammar when learning a language, music theory helps musicians understand how music is structured.
Music consists of a combination of pitch (single sound), horizontal (several sounds played in sequences to create a melody), vertical (several sounds played simultaneously to create harmony) and rhythmic elements. When combined, two or more of these elements create a unique composition.
Music theory is a framework for describing how these four musical elements combine to create a composition. Music theory also includes the study of the rules and conventions of composers from different periods, and composition schools combine the elements. For example, the harmonies of a Bach composition differ considerably from those of jazz today.
Like music theorists, real estate investors also have methods for describing how to value a property. At the most basic level, real estate investors are concerned about how much money they need to invest the property (which I will call “cash out”) and how much money they will receive from the investment (which I’ll call outside “).
As with music theory, there are several methods that investors use to assess profitability. But they all start by looking at the inflow and outflow of money.
This article is one of a series on methods used by investors to assess the profitability of investments. This article is about âcash returnâ.
What is Cash-on-Cash Return?
Cash return calculations take into account only two numbers: the money an investor has invested in the property and the annual money the investor receives on the investment. The cash return formula divides the annual cash outflow (annual cash distributions) by the total cash flow (total cash invested in the property):
Cash-on-Cash Return = Annual Cash Out / Total Cash In
The cash return is usually expressed as a percentage. For example, if an investor paid $ 1 million for a property and received $ 50,000 per year in cash from the investment, the cash return would be five percent (5%).
How to use the cash-on-cash return to evaluate an investment?
The cash return is useful for investors who are focusing on the annual income from their investment. A cash return assessment can help investors compare two investments that require the same down payment.
The cash yield is a reasonable substitute for investment interest. Therefore, it can help investors compare a real estate investment with other types of investment.
Consider this example:
Maria and Jessie are a retired couple who depend on their investment income to supplement Social Security. They have $ 1 million in a long term certificate of deposit that only provides one percent (1%) interest or $ 10,000 in cash per year. With their cost of living increasing, they need at least $ 30,000 in cash per year from their investment to avoid withdrawing money from their capital. Their investment options are to put $ 1 million in one of the following:
1. Real estate investment in an apartment building providing for a cash return of 3.5% ($ 35,000) for seven years and an investment return of $ 1,000,000 on the sale of the property at the end of the year. the seventh year.
2. Ineligible annuity from an AAA rated insurance company that pays $ 50,000 per year for 25 years.
3. A $ 1 million AAA-rated corporate bond that pays 3.5% interest ($ 35,000) each year for ten years, with return of principal at the end of the tenth year.
4. A $ 1,000,000 AA tax-exempt bond issued by the state in which Maria and Jesse live that pays 3.4% interest ($ 34,000) annually for seven years with a return of principal. at the end of the seventh year.
Looking only at the cash return, Maria and Jessie buy Investment 2 because it will give them the highest annual income, and it guarantees that income for 25 years, much longer than other investments.
What cash yield doesn’t measure
The cash return offers an easy way to compare investments and can be useful for investors who need cash income from their investments. However, the cash return calculations do not take into account several factors that may be important when valuing an investment, especially when, as in the example above, the cash return of an investment Real estate should be compared to the cash returns of other types of investment.
The cash return does not take into account the tax advantages (or disadvantages) of the investments. And more importantly, the cash-on-cash return does not take into account the risk of default during the investment period. A cash-on-cash return also ignores the time value of money, a complicated concept beyond the scope of this article.
In the example above, investments 2 and 3 (the annuity and the corporate bond) are rated AAA, the highest investment rating. They therefore have the lowest risk of default. Investment 4 (the tax-exempt bond) has a high AA rating, so the risk of default is also low.
Most real estate investments are unrated. This does not necessarily mean that they have a higher risk of default than rated investments.
However, the investor should take a close look at the financial forecast for the investment to assess default risk and determine whether the underlying assumptions are conservative, aggressive, or somewhere in between. Most investors have neither the experience nor the interest in delving into forecasting to make this assessment.
Based solely on the risk of default, investments 2 and 3 are the winners.
The cash return does not measure the tax advantages (or disadvantages) of an investment. Suppose Maria and Jessie have a combined federal, state, and local tax bracket of 30%.
Investment 1 is a real estate investment and will produce depreciation deductions to offset part of Maria and Jessie’s cash return. Suppose 10% of the $ 1,000,000 investment is allocated to the land and 90% is allocated to the apartment building. Land is not depreciable and multi-family buildings are depreciated over 27.5 years.
In this case, Maria and Jessie would receive a capital cost allowance of $ 32,727.27 each year, which would reduce their taxable income from the investment. This would save them about $ 9,818.18 each year in taxes, as they would pay tax on just $ 2,272.73 of their cash return for a total annual tax payable of $ 681.82.
Investment 2 is an annuity. To simplify the math, even though Maria and Jessie would receive $ 50,000 per year, 80% or $ 40,000 of that money would be a tax-free return on a portion of their initial investment. This means that they would pay taxes on only $ 10,000 of cash and they would have a total tax payable of $ 3,000.00.
Investment 3 is a corporate bond, so all of the $ 35,000 Maria and Jessie receive each year would be taxable. They would pay $ 10,500 on their annual return.
Investment 4 is a tax-exempt bond. Assuming their state does not charge interest on its own bonds, their total income tax payable on the investment 3 would be zero.
Looking only at the tax ramifications, Investment 4 is the winner.
What about real estate?
You may have noticed that real estate investing wasn’t the winner in any of the reviews in this article. Although cash yield is frequently used to value real estate investments, it does not give the full picture of the benefits of investing in real estate.
As demonstrated above, with capital cost allowances, real estate investments can provide a legal way to shelter income from tax. To the extent that Section 1031 is available, real estate investors can legally defer taxes on their gains from real estate investments.
Real estate can help investors diversify their portfolios to minimize portfolio risk. And real estate can be a good hedge against inflation.
Real estate can also rise in value. So, the biggest benefit for real estate investors is the gain when the property is sold, rather than the cash income they receive while holding the investment.
Cash-on-Cash does not give the complete picture
Music theory is not just about melody or rhythm. He analyzes entire compositions. Investors should do the same.
The examples in this article make basic assumptions to demonstrate the limits of cash return in valuing investments. Real investments and tax situations are likely to be more complex, especially with real estate investments.
While cash returns are easy to calculate and can provide a basis for comparing real estate investments to other types of investments, this metric does not give the complete picture. And as investments and tax situations become more complex, cash returns are less likely to present the full picture of an investment. For investors who recognize its limitations, a cash-on-cash return analysis can be useful, but it is only one tool among many that a potential investor should use in deciding when to invest.
This series draws on Elizabeth Whitman’s experience and passion for classical music to illustrate creative solutions to legal challenges faced by businesses and real estate investors.