Why You Should Use the Cash on Cash Return Metric | Short Term Rental Investing

So there are a lot of metrics out there for us to be able to analyze our properties to know if they are a good return or not. But I have one favorite and one that all of you should be using. I want to break that down this week. Welcome to Short Term Rental Riches. We'll discuss investing in real estate, but with a specific focus on short term rentals. Quick actionable items to acquire, manage and scale your portfolio. I'm your host, Tim Hubbard.

Welcome back to the Short Term Rental Riches podcast. I am happy you are here. And it is a new year, isn't it? 2023. Gosh, every time we add a year on it, it feels like we're just that further in the future. Well, I hope you have some great goals lined up and hopefully you don't leave them until the end or the beginning of every year to create them and to think about them and to plan. Goal planning is something we should be doing all year long. And the sad truth is that most people spend more time planning their vacations, which is good for us as short term rental investors. But most people spend more time planning their vacations than they do their lives. And that is a sad truth. So I hope you have some great goals lined up for the next year. Okay, without further ado, I wanna talk about a metric that we should all be using every time we purchase a an investment property or anytime we're thinking about purchasing an investment property. And there's a lot of different metrics out there, but the cash on cash return, in my opinion is the most important because we want to invest for cash flow. That's something we can know right from the moment we purchase a property, if it's already occupied, versus other types of investments, stocks, for example. So we don't know how stocks are going to perform in the future. We like to think we know where they're going, but the reality is that's way out of our control versus real estate, where we have control over our properties. And so I always recommend that we know exactly what we're getting into when we buy a property and we don't speculate on appreciation. Now, I know in today's economy appreciation is not really happening, right? In fact, it's going the opposite way and homes are decreasing in value. So hopefully you weren't investing for appreciation. There are still properties out there where we can cash flow and that is the name of the game, right? It doesn't matter what happens to the value of our property if we're making money on it month after month. And Our expenses are fixed. So I want to talk about how to calculate that, some considerations and let's just go from start to finish. So first of all, what is our cash on cash return? Well, it's how much cash we get back versus how much we invested in the property. Now there's actually multiple ways to do this, right? We need a timeline to be able to calculate the cash on cash return. But I'll talk about the most normal way to that first. And that's based on a year long time period. So if we are going to buy a property, we first need to know all of the income that it's either making right now, if it's already rented or what we are projecting into the future. And now I, I recommend being very, very conservative. Rent projections. Remember we can use tools like airdna all the rooms. There's data from beyond pricing and price labs co if you're using any of those pricing tools. So we can get an estimated amount of short term rental income in the future. But remember, it's not guaranteed versus if we're buying traditional rental property that already has a long term tenant in there and they're already paying a month monthly amount. And as you know, if you've been listening to the podcast for a while, that is my ultimate backup plan. So that's how I underwrite it to start off with. So first we need to know all the, all of the income. If it is a long term rental, then you know, any monthly fees on top of the short term rental, Maybe you're charging back for utilities or something like that. If it's a short term rental, well then we have our estimated short term income. We also have our cleaning fees, pet fees, anything else you might think you might be able to collect from that property. Then afterwards we need to deduct all of our expenses, right? So if it's a long term rental, we're going to be deducting maybe management fees. We're very likely going to have very little utilities. But maybe landscaping, pest management versus a short term rental. We have much more expenses, right? So we definitely have utilities, we have Internet, we have HOA fees. If we happen to be in a place that has hoa, we have landscaping, we have maintenance costs. And remember, if you're buying an older property, you always want to estimate higher maintenance costs because older properties, well they don't hold up usually as well as newer properties, right? So you want to make sure that you have an expense in there for maintenance. So we're going to take all those expenses and deduct them from our income. So remember, your biggest expenses though, no matter whether it's a short term rental or a long term rental, are going to be your property tax, taxes, your insurance and your mortgage. If you have a loan on the property. But remember the principal pay down, that happens every month. Every time a mortgage payment gets made, that's not actually an expense, right? So you want to make sure that you take that out. That's one of the beautiful things about real estate is that our short term rental guests or our long term tenants are actually paying down our properties for us. Right? So hopefully at the end of the day, after all those expenses, you have net income left over. That is the name of the game. Game. That's what we strive for. Not appreciation, not speculation. And I heard it said really well recently, is that if we're investing based on probabilities, right? So conservative rent estimate and accurate expense estimates, those are probabilities versus possibilities. And that's thinking, oh, I can improve this property a whole bunch and I'm going to double the short term rental rent that's going to come in. That is a possibility which we could in other words call speculation. Right now, past performance is never a guarantee of future performance, but it's definitely a lot more probable than just thinking we can do much, much better than some property did in the past. Right? Okay. So we've taken all of our expenses and deducted from all of our income and hopefully we have net income left at the end of the day. Now the cash on cash return calculation happens here, right? So let's say a quick example. Let's say you bought a property for $100,000. I. Those probably do not exist, right? And you put $20,000 down as a down payment. And then throughout the year, your mortgage or insurance, your utilities, whatever it happened to be, cost you another $10,000. So this $100,000 property, you have a total of $30,000 in cash out of pocket into the property. Now let's say that after all those expenses, you made a net profit of $10,000. That would be really good, by the way. That would be a cash on cash return of about 33.33%, right? It cost you $30,000 to get into that property and you made a third of that back in the first year. That's pretty darn good. Now let's talk about what you should actually expect for a cash on cash return. Let's start with long term rentals. It used to be in the not so distant past that you might be Earning single digits if you're in a decent market. We used to strive for 10% maybe three, four years ago, but that just became less and less even with lower interest rates in the recent past. Now I would say, unfortunately, again, all markets are different, but you're probably looking at like a 0% cash on cash return with these long term rentals. Again, that is not for every market. I know there's always opportunities, but interest rates have doubled. And if cash on cash returns just recently, six months, a year ago, were very low to begin with, well then they're probably zero or even negative. Now remember, the cash on cash return is not accounting for tax benefits. And so we know as real estate investors that we have some really fabulous tax incentives. If you don't know about them, please go back and check out some of the prior episodes. We've got one with Tom Wheelwright, who's Robert Kiyosaki's accountant. You can check out his advice. We've got one with my accountant a little further back. And so we talk about that topic quite a bit. I am not a tax professional, but they are and we've got it on this channel for you. Now, what should we expect as a short term rental, cash on cash return? Well, I will tell you that I have properties that have ranged everywhere from 20% per year to over 50% and I still have properties doing that. Well, we've got to remember though, when we invest in short term rentals, we have more upfront investment normally, right? So we have to buy furniture. Sometimes we're renovating the property a little nicer than maybe we would if it was a long term rental. So got a lot of upfront costs with a short term rental. Right? So let's take the same calculation over two years and let's say in year two we had an additional $10,000 in expenses just like we did in year one in terms of utilities and property insurance and taxes. But after all that, we made an additional $10,000 in net income. So now we have a total of $40,000 in cash out of pocket. Right. $20,000 in expenses over the two years and 20,000 DOL as a down payment. But we've netted $20,000 after those two years. So if we take the annualized cash on cash return over the two years, that's 50%. That's really good. Right? So you can see that with short term rentals, a lot of times in the second year our cash on cash return can go up quite a bit because we don't have that original investment in furniture. So I recommend that you run your projections not just on the first year, but also on the second and third and fourth years as well. A couple other things here. Let's say your cash on cash return is 0%. Remember, if you're getting those tax benefits and you save 10% off of your taxes from expenses, eligible expenses from your real estate that you could use to offset other income, well, that could still be a really good return for you. So you definitely want to make sure that you're considering those as well. Let's talk about loan impacts for a second here too. We all know that interest rates are going up. What does that do to our cash on cash return? Well, if our loan cost doubles, that's going to mean our expenses, our mortgage payments going to go way up. That's going to put downward pressure on our cash on cash returns. Right? But we still need this metric to know and to be comfortable with the property before we pull the trigger on it, because it's going to help us calculate that. But one metric you might hear out there in the real estate world that doesn't actually account for mortgages is the cap rate. So I remember using the cap rate a whole bunch when I used to work as a commercial broker. And it's still a very valuable metric. And it's more often used with larger apartment complexes and shopping centers and much bigger deals. But it doesn't actually account for debt. Right. The cap rate is basically the net income divided by the purchase price of the property. And the net income is not accounting for mortgage. So don't get caught up and be using a cap rate to calculate your potential returns with the property. We want to be using cash and cash return, assuming you are using a loan to purchase the property. So make sure that your property makes sense when you're buying it. Right? That is the most important thing. The value isn't going to matter as long as our costs are fixed. Right. As long as we have a fixed mortgage payment. If after all your expenses, you are making positive cash flow, well, then I would consider that investment. Remember, every market's different, so there's opportunities out there. But this is a metric that can really tell you if it's worth moving forward or not. And I'll leave you with just one last thing that's really exciting about real estate. We might not have this opportunity in the near future, but it is an opportunity. And the longer we hold real estate, if we can ride out the lows, then we earn equity in our property, right? As we're paying it down. Hopefully we're in a market that's still growing and we can earn appreciation when the market is going in the right direction. And assuming those things are happening and we can refinance our property in the future when we do have equity in it, we can take cash out, a cash out refinance. Which means what happens to your cash on cash return if you take all of your cash out or even half of it through a cash out refinance? Well, then your cash on cash return goes through the roof even to the point where you have $0 in a property and then you're earning an infinite return. And I challenge you to find another investment area where you can earn an infinite return. It just doesn't really exist. So hopefully that gave you a good overview of cash on cash returns and how important they are and how important it is that we understand how they work. Until next time, I hope you have a wonderful week and a happy new Year and I will talk to you soon.

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