#65: How to Evaluate Investments With Cash on Cash Return

Foreign welcome to the Passive Income MD podcast where we talk about creating your ideal life through multiple streams of income. I'm your host, Peter Kim. If you enjoy hearing about this stuff, make sure to hit subscribe so I can bring it to you every week. Now let's get on with the show. Hey everyone, how's it going out there? As you can imagine, I often get this question, what's the best way to evaluate an investment? Now, as a physician and high net worth individual, once you kind of put it out there that you're looking to invest in some of these type of investments, particularly like the passive real estate investments or I mean even angel invest, or do any of these type of things, deals tend to find their way to you. I mean you can put it out there and you'll either start getting ads on Facebook, some of your friends might start telling you about these deals. Especially if you're in certain Facebook groups or forums, you'll find your way and land onto these type of deals. Now when you look at them, how do you actually determine whether it's something good for you, like whether it fits your goals and whether it fits what you're trying to do with it? Now everyone's looking for that amazing return on investment, otherwise known as roi. That's the funny thing when you talk about these investments, like you start looking at these numbers and you start seeing things like irr, which is also known as the internal way to return, or the cash on cash. You know, you're trying to figure out, okay, why are these numbers different first of all, and then how do I actually interpret these to make sure that I'm actually choosing something that works well. Now obviously you don't make your whole decision, investment decision, based on the returns or the potential returns, because one thing you'll learn is that people that are putting on these deals, they can manipulate these numbers just to make it look good and dangle it on the front end. And then you'll find that some of them will end up under delivering down the line. So that's not what you're looking for. You're hopefully looking for someone in a group or whether, you know, whatever you're looking for that will under promise and over deliver right will be conservative in their underwriting. So that, you know, whatever numbers that they put out in front of you, there's a good chance that they're gonna actually exceed those. Now the question is, how do you find those? And that really has to do with doing the proper due diligence, learning how to do that correctly We've talked about that and we'll continue to talk about that on podcast after podcast. Obviously, we talk about that a ton in one of our courses, Passive Real Estate Academy. But it's always kind of tricky, right, how to figure out how to best evaluate an opportunity. So I thought it might be important to talk about some of these key metrics. And in particular, I want to talk about the cash on cash return today. Now, that's like my favorite calculation, just because it's really simple and it makes it, it's very clear what that means. So let's talk about that right now. Now, when I talk about real estate investment calculations, I mean, I know that a lot of people automatically think that, okay, this can be really complicated, this would be really difficult. But I'll just tell you, a lot of it is math that I'd say my third or fourth grade kid. Oh, my third grade kid knows how to actually do it. Has a lot to do with addition, subtraction, multiplication, and division. And that's about it. So I promise you, almost all of this you are able to do on your own. And so the cash on cash one is definitely one that you can understand. And it's a quick way for you to look at investment, try to figure out what works for you. So here's the definition of cash on cash return. It's the annual before tax cash flow divided by the total cash you invested. So it's the annual before tax cash flow over or divided by the total cash you invested. So let's say for an example, you put about $10,000 into a real estate crowdfunding deal, right? That's the total cash you invested, and you receive $1,000 over the course of the year. So that's like your annual before tax cash flow. In this scenario, you have a yield of 10% cash on cash returns, which is your $1,000 over your $10,000. So when you're looking at like a rental property, for example, just to make it a little bit more interesting, you would take your operating income. So how much income you receive, you subtract out all your expenses, like your mortgage and all the other expenses. And that's like your net income or net cash flow. And then you divide that by the capital that you invested or your down payment. So that's one way to calculate when you look at rental properties. Now, why do I like the cash on cash return metric, right? Or that calculation, what are the strengths of it? Number one, it's simple. It's the greatest strength of this cash on Cash calculation really lies in its simplicity. You're going to see these things called irr internal rate of return. I promise you. We'll talk more about it in another podcast. It can be quite confusing. People will have a hard time wrapping their head around that calculation. But when it comes to cash on cash at the end of the year, how much you get put in your pocket over how much you initially invested. And that's a good number, right? So it's super simple and I absolutely love that. Number two, it can help you to compare investments pretty quickly. So when you look at two different investments, especially when you're like looking at either two different rental properties or you're looking at two different passive real estate investment deals, if you have an idea of what that investment might yield as well as how much you may want to invest initially, you can calculate that cash on cash, right? That of what you think it could be, right? And it can quickly help you see how investment might fit into your portfolio versus another one, right? Especially if you have goals for how much cash flow that you want to receive on a yearly basis. The cash on cash return calculation is also useful for seeing how certain factors you know, if you change them, how could they, how they could affect your returns. For example, let's say you're looking at an investment property and you're trying to figure out whether to put pay all cash for it or whether you're trying to use leverage. You know, let's say you want to put down 20 or 30% instead of paying all cash for it, does that change your return? One way to quickly assess that is by using the cash on cash calculator. And then that might help you determine how much leverage to use. And in that case, you always got to weigh the risk of leverage versus how much the return like I'd say, improves by actually using that leverage. And that cash on cash calculation can help you do that. The next thing I call encourage and motivation. I mean, the cash on cash return, it provides a good amount of encouragement and motivation. I mean, it's nice to see like if you have a stock portfolio, right, it's nice to see it go up and down. You know, you kind of go up and down with me, but nothing is exciting to me as getting that like deposit in your bank account, right? Either the beginning of each month, each quarter that comes from having that cash flowing passive income, right? That's why I absolutely love real estate is the fact that it creates that monthly or quarterly income for you that you can use. And number one, obviously it Feels great to see that come into your pocket. And it's encouraging to find out and see for real that you didn't have to put in extra time at the hospital clinically to receive that income. I mean, I remember the first check that I got, a $47 check or so it was, that actually gave me that extra income. I mean, that pushed me to do more. It made me hungrier for more time freedom because I saw that where it could go. And lastly, you can live off of it. And that cash flow that you get, I mean, that's the whole reason you can use that cash flow for whatever you want. I mean, obviously you can buy some things for yourself. You can do that. I found that the best use for that cash flow is to buy my time back. Meaning that if I knew that I could give up a shift and that would cost me X amount, if I had that money coming in from another source, yeah, I would just give it up. And I was able to buy my time back and what I typically call gradual retirement, little bit by little bit, as that cash flow started to increase, I reduce my clinical time to match that. Now there are some weaknesses, some downsides to the cash on cash return. Some things you have to consider. Number one, it doesn't take into account taxes. Now, it's obviously a big concern of all of us. I mean, everyone's tax situation is different, as is how the investments are treated is completely different. So it's really important to consider all of that to understand how that cash on cash return does or doesn't take into account those taxes. For example, I live in Southern California. I live in a high cost of living area. And the state income tax is like pretty high. Right. Compared to a lot of my friends who are in Texas or Florida, where you don't have that state income tax. I know I'm jealous whenever I hear about it. Now, I think someone like that might look at the cash on cash return number a little bit differently than I would. Right. So we have different goals, different needs, that sort of thing. Also, the cash on cash return, depending on the type of investment, it might underreport your profit potential. Right. In real estate, I've talked about it before, the cash that you receive, the cash flow, it's my favorite part of the investment. But it's not the only way that you make money. Now, I know that when people try to compare real estate and stocks, they often talk about that, oh, this is how much cash flow you received. Oh, you could have received a lot more if you had just Kept it in the stock market. And I get that. But you know, that doesn't. That only takes into account part of what makes real estate so powerful. Number one, obviously you get the cash in your pocket. Number two, if you're having renters or like you're invested in a investment that has renters, they're paying down the mortgage or principal as it goes, right? Another thing is that the property appreciates with time. It goes up in value over time just as low as the, you know, just as those stocks do. Right, over time. But you're getting cash flow and you're getting appreciation, you're getting that mortgage or principal pay down and then you're getting some bunch of tax benefits. When you actually think about the cash on cash calculation, just know that it can vastly under report your actually true profit potential. And so you have to understand when you're looking at that, you know, is it a type of property where the cash flow is a majority of that return or is it a little less, there's more appreciation. Um, that sort of thing is something that you have to take into account when you look at these investments. Now I know what you're asking, when you're looking at these investments, should you only use the cash on cash calculation? I mean. Well, the answer is honestly no. And because risk and opportunity costs are important factors, consider. Let's look at each of them really and talk about it really quickly. So risk returns often correlate with risk, right? You know, there's no free lunch. As risk goes up, your return potential typically goes up. And as things are a little bit lower risk, typically your return potential goes down. So in real estate, you definitely have to look at risk as well. Like what kind of project are you looking at? For example, you might see a ground up development deal, right, that has an amazing potential, but there's a ton of risk involved. But in that situation, you're probably not having a lot of cash on cash because the property is being built, it's not producing any sort of income. Now there are those other really high quality properties or investments that are running super well and don't really have a lot of upside, but it's very stable. In that case, you might look at the cash on cash return and see that it's kind of low. Maybe you're like, you know what, I don't know if that's a great investment for me. But the thing is, the risk is very low in that situation. So if you're building a portfolio and you're putting together different investments, it's important to think about risk in addition to cash on cash return. Now, we also mentioned the opportunity costs. You have to think, are there better places to put your money? That's what it means. Is our cost an opportunity where you could have put that money and perform better. Now, if you decide only by using the cash on cash calculation, you might always chase the highest cash on cash number. Now, I will tell you, as I mentioned before, people can obviously say what they want in terms of what the cash on cash calculation will be. You know, cash on cash is just one part of the equation, one way to make money. But just realize that it's just one part of the story. It may not be the best fit for you to take on the highest cash on cash return because maybe you're looking for more appreciation potential. Maybe you want something with better tax benefits. All of that stuff is stuff that you need to take into account when you look at investment. Now, I will tell you, there is a big difference in investing purely for speculation, right? Or purely for what they call appreciation versus investing for cash flow. Now, positive cash flow. Just so, you know, people consider that a little bit safer to invest with, right? Because it allows for operations to continue, especially when revenues drop a bit, because you got that buffer. I mean, I think that people learned a big lesson in 2008 when they learned that, hey, these rental properties, you can't just buy anything and just hold it and sell it later for more. It has to have some cash flow that can kind of weather the storms. Now, obviously, with everything happening with COVID you know, obviously rent going down, it was just an interesting time. But luckily, a lot of the investments that I had had great cash flow in place to make sure that they were able to cover any sort of drops in income. And we're able to cover that difficult time, especially when Covid first hit. And I hope this is the same for you, right? I mean, it's all about finding that nice balance, right? Or just kind of mix and matching your portfolio to make sure that you're taking into account risk, a little bit of speculation, that cash flow. But I will say that the cash flow and the cash on cash, I mean, it's what really changes your life at the end of the day. I mean, yes, it'd be nice to hit the lottery 20 years from now, but my goal has always been to live and take the most advantage of my life right now. While I'm young, I'm healthy, I have my children in the house. I want to enjoy life now because the future is Never guaranteed. Obviously there's a balance there, but you know, having a good portfolio of cash flowing properties or cash flowing investments helps you to do so. So if you're just starting out and you're trying to figure out how do I start with the evaluation, A good place to do it is by figuring out what the cash on cash return is. You're going to find out how your money's being put to use and what you should expect to get back from it. Real quick. For those who have been asking us about more resources or where to find resources for finding out more about real estate investing and doing the proper due diligence, I want to tell you about two real quick that we can't talk about enough. Number one is our big virtual conference. We do a real estate conference every year actually. This is the third annual one and it's called the Financial Freedom through Real Estate conference, happening in 2021 on September 10th through September 12th. Now it's gonna be completely virtual. Um, I would love to do it again in person. Hopefully we'll get back to that soon, but it will take place online. Please look out for it. Not only do we have amazing speakers that we're gonna about to announce that are experts in the field of both active and passive real estate investing. You know, in areas of asset protection and taxes, everything you need to essentially start your investing career when it comes to real estate and find the right resources. We're so excited it's going to take place soon. So look out for that and tell all of your friends about it. Just like last year, just like we do with most of our conferences, it is going to be completely free. So we want to put those resources out there for you. For those of you who want to kind of upgrade your experience, there will be a VIP all access pass available for you. But either way, we want you to be able to enjoy it from the comfort of your own home or poolside or whatever you might be. So look out for that. Number two, we're going to be launching our fall class shortly after that for Passive Real Estate Academy. For those who don't know. And for those of you who are interested in investing in passive real estate, it essentially teaches you in four weeks how to invest confidently, you know, without being a landlord. I mean, for many people, that's kind of the desired way that they want to invest in real estate. And there are opportunities out there and that I've learned about and I think that it's important to be able to figure out how to find these opportunities. Number two how to vet them out. Make sure you're making a good investment decision and avoiding, you know, making a bad one. And then after that, you know, you want to have community of people who are vetting deals with you, sharing resources. We provide all that within the, I'd say the boundaries of Passive Real Estate Academy. Look out for it. If you haven't seen it or heard about it yet, you can go to passiverealestateacademy.com you can join our wait list. Our waitlist will get a, you know, couple hundred dollar discount as well as some extra bonuses. So really there's nothing to lose. If you get on the waitlist, we'll let you'll be the first to hear about it. Okay. And have that opportunity. So passiverealestateacademy.com look out for it. And it's coming in September. Anyways, have a great week. Hope that's helpful. Let's talk again soon. See ya. Enjoy the show. Let me know by dropping a review in the podcast app you listening to us in. And if you haven't already, make sure to hit subscribe. Are you part of our community yet? Join thousands of physicians who are also on this journey to creating their ideal lives through multiple streams of income. You can join us on our Facebook group Passive Income Docs and you can always learn more at our website passiveincomemd.com thanks again for allowing me to be a part of your journey. See you next time.