Taking your portfolio to the next level with
On Cash returns
Developing an understanding of On Cash returns will completely change the way you research and understand investments. While they’re most commonly used for assessing property, the concept is relevant across the investment spectrum.
On Cash returns identify the performance achieved by the capital you actually invest into an asset. On Cash returns can therefore be used to benchmark performance, assist with profit optimisation and provide the investor with a deeper understanding of where investment return risk may exist for a particular asset.
The calculation is also more comprehensive than many equations, like net rental yield, given it considers all associated property costs (including loan interest, principal and fees). In Australia, On Cash returns have additional importance as this is often the go-to metric when comparing the performance of a property in an SMSF to industry and retail super funds!
Let’s investigate how to calculate this metric with the following example:
An investor purchases a property with all-in costs of $400,000. They successfully apply for a $320,000 loan with the remaining $80,000 being funded via cash savings. The property provides a net return of $8,000 in the first year after all borrowing costs. The investor renovates the property in year two, with the bank funding $40,000 and the investor funding $10,000. The property provides a net return of $30,000 in the second year after all borrowing costs.
On cash returns are fundamentally described by the following formula:
Net Return / Capital Invested = Return on Cash
The Total Return on Cash in the first year of the above example is therefore very easy to calculate:
$8,000 / $80,000 = 10.00%
However, it becomes slightly more complicated in the second year as a result of the renovation. Our $80,000 initial capital investment has increased by $10,000 (which was the amount that was personally funded to meet renovation costs):
$30,000 / ($80,000 + $10,000) = 33.33%
How do you calculate On Cash returns?
What should you include in your Cash on Cash and Growth on Cash calculations?
By breaking down our Total Return on Cash further (to Cash on Cash and Growth on Cash) we can assess where we will achieve our investment return (via cash flow or capital growth).
Naturally, by understanding exactly how we are generating our financial return we are able to better-assess where the risks to achieving our investment returns may exist.
It is noteworthy that the Australian property market is typically growth-orientated, often resulting in negative Cash on Cash returns.
However, cash flow is beneficial for those wanting to acquire additional assets over time, diversify their portfolio and reduce reliance on capital growth to singularly produce returns.
By breaking down our Total Return on Cash further (to Cash on Cash and Growth on Cash) we can assess where we will achieve our investment return (via cash flow or capital growth).
Naturally, by understanding exactly how we are generating our financial return we are able to better-assess where the risks to achieving our investment returns may exist.
It is noteworthy that the Australian property market is typically growth-orientated, often resulting in negative Cash on Cash returns.
However, cash flow is beneficial for those wanting to acquire additional assets over time, diversify their portfolio and reduce reliance on capital growth to singularly produce returns.
What should you include in your Cash on Cash and Growth on Cash calculations?
There is no such thing as a perfect investment metric and On Cash returns do have specific pitfalls. For example, the same investment will have magnified financial returns (both positive and negative) as the Capital Invested reduces. Therefore, a high-quality investment may appear to underperform a lower-quality investment where the lower quality investment has additional gearing.
On Cash returns also don’t provide any meaningful indicator for some risks, like over-borrowing and affordability. As highlighted above, increasing the amount that we borrow to invest will result in the magnification of the financial return. Naturally though, increasing our gearing increases our risk. As interest rates rise, the net financial return achieved by an investment with additional gearing will reduce more rapidly (due to additional interest payable) than one that has lower gearing levels.
Finally, Cash on Cash returns are also calculated based on the net return less all regular borrowing costs. Given the popularity of Interest Only loans in Australia, the costs that you use may or may not include repayment of principal. Where principal is not being repaid, the ongoing investment costs will be lower, artificially inflating the net financial return. While this is not a problem when comparing an Interest Only strategy to other Interest Only strategies, it will provide a false indicator of superior performance if compared to a Principal and Interest strategy.
We can actively avoid the above pitfalls by following some simple rules:
- Ensure the percentage of capital invested is the same across all properties you research and compare.
- Don’t rely on any single indicator for performance. Always overlay your results with other metrics such as those relating to debt serviceability and cash flow.
- Undertake comparison research with the same type of loan strategy, typically minimum Principal and Interest or minimum Interest Only repayments.
Learning to use On Cash returns will improve the quality of your investment research as well as the conversations you have with professionals and other investors. They typically provide a more complete understanding of investment performance and can be used to effectively compare the return of a geared asset to non-geared investments (like many super funds).
Use On Cash financial returns in your property analysis. Access a free three-day trial or one of our subscription packages today.
About the author: Brenton has more than ten years experience in the financial planning industry. His specific qualifications include financial planning, margin lending, SMSF (self managed super funds) and direct shares. He is also an experienced investor.
Last reviewed: 30 May 2022
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