Cash on Cash Returns for Rental Properties

Financial Place Online test fired their “Complete Landlord Calculator” today.  The first test involved what is referred to as “Cash on Cash” return.  The “Cash on Cash” return is the percentage of annual cash received vs your initial investment.  This is an important return as it defines how your investment cash flow looks.  A negative return indicates that the house is sucking up money.  Higher positive returns can be had with better management of the underlying financials such as interest rate, purchase price, and rent received.  A higher rate can also be had by increasing the amount of leverage of your investment capital.

Leverage of Capital:  The ratio between your invested capital and the purchase price of the asset.  In the case of a $50,000 investment and a $50,000 purchase price, the leverage is 1:1, or more simply expressed as 1.  However, if the investment was $5,000 for the same $50,000 asset as would be done through using the bank’s money to cover the other $45,000, the leverage would be 10.  A higher leverage will return a higher rate of return for investments who return a rate greater than the weighted averaged cost of borrowing.

The problem with using leverage is that negative returns get exaggerated in the same way.  This deals with both cash flows and a decrease in value of the underlying asset.  Using the $50,000 asset with a leverage of 10, a $5,000 drop in value wipes out all of your investment, since the bank still needs to be paid.  In most all cases, the bank has secured the loan by your asset, so they will be the first to be paid in case you have to sell.

The below chart shows an example case of “Cash on Cash” returns plotted against the amount invested.  The investment being examined has the following characteristics:

  1. This is a house priced at $150,000
  2. Your out of pocket closing costs are $1,500
  3. The mortgage is for a 30 year term
  4. The interest rate is 4%
  5. The rents collected is $1200
  6. Property management takes 10% of rents collected
  7. Occupancy rate is 95%.  Many rental markets are on fire right now
  8. Property taxes at $1500 per year
  9. Hazard insurance is $300 per year

Cash on Cash>>> The chart shows a very high rate of return in the case of 0% down (just the $1,500 closing costs).  From here the rate of return decays exponentially until it flattens near 6.5%.  This amount is the unleveraged rate of return.  Again, remember that too much leverage can be dangerous.  In the case of residential real estate, a healthy amount of leverage can be had between 10% and 30%, and will vary from opportunity to opportunity.  There was entirely too much dealing done during the sub prime era of real estate lending where 0% down deals were permitted on rental properties.  The highly leveraged cash flows swung to the negative after the crash and many investors did not have the cash on hand (which is why they did 0% down) to cover the losses, and thus lost their businesses.

 

Rent subsidies, section 8 housing

There are several different rent subsidy programs, the most common of which is section 8 housing through the HUD. These programs are vouchers which low income households can qualify for and use to pay for part/most of their rent. It is interesting to note that these vouchers ultimately wind up as paid rent and in the landlord’s pockets. Another effect is that these vouchers raise the demand for lower income housing for a given locality. A voucher program drives up the rent on houses at and near the bottom of the market. It is also a contributor towards establishing a steady rent floor. A rent floor is the bottom of the local market where a bunch of close houses exist at a price. In an example area, it’s $900/month for a single family house. These are the houses that are pushed up by the voucher program. A much nicer house can be had for $1200/mo. It also works out, that based on income qualifications, it is hard to get into a house greater than $1100 on the voucher program. The rent ceiling in this area is at $1250 right now.

The lesson behind this: Research the local market if you plan on being either a tenant or landlord and find out how to best take advantage of economic trends dealing with rent floors and rent ceilings, and the spread between the two.

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