Methodology in calculating cash yield

David
The IRR is taking into account the equity build up. Whether you can take it out or not there is money going to principal and that money is yours. Once you calculate NOI you now take off debt service to get net operating cash flow. However when you calculate ordinary income for taxes you only deduct interest. The result is a higher amount than net operating cash flow. You are now going to pay tax on the money that went to principal. Have a look at the calculation.
Net Operating Income $70,000
Less: Debt Service
Loan 51,894
Total Debt Service $51,894
Net Operating Cash Flow $18,106
Taxable Income and Taxes
(Losses Carried Forward)
Taxable Revenues $70,000
Less: Deducted Expenses 0
Less: Interest Expense 45,291
Ordinary Income $24,709
Taxable Income 24,709
(Cum Suspended Losses) 0
Taxes Due (- = Savings) 9,693
Cash Flow After Tax $8,413
Even though you may not be able to distribute principal reduction to investors you are paying tax on the money. The IRS thinks it's "real". paulsylvester@remax.net
Paul Sylvester,CCIM

your analysis does not include depreciation : therefore tax liability is lower...

The example I used was to illustrate that the money that goes to principal is in fact cash that is attributable to income. By showing the difference in the net operating cash flow and the ordinary income I believe that was demonstrated? Depreciation would of course reduce the amount of taxable income and therefore increase the after tax income. It would not however change the fact that there is a difference between net operating cash flow (where principal and interest is deducted) and taxable income (where only interest is deducted).

I agree David it is misleading regardless of the income tax effects. Traditionally cash-on-cash return or yield is a measure of the pretax cashflow after debt service (P&I) have been deducted. Usually in year one or stabilized. That is far different than IRR which, as correctly pointed out, is the time-weighted average return of the asset over the life of the investment. That does factor in equity accretion from the debt amortization. I cant believe the hungry broker would try to make his asset which is yielding a measly 5% look like it is actaully yielding 9%!

The answer is simple. You are correct. It is not appropriate to add back amortization in calculating cash on cash yield or "equity divident rate" as termed by the appraisal profession.
J. Mark Stroud, MAI, CCIM

Gentlemen you're all correct. But, one more factor has to be added to the equation. As esoteric as it amy seem, a calculation must be generated that clearly reflects the added erosion of value, over and above normal depreciation, in today's unique negative market environment which also includes an inflation driven erosion of the value of the dollar that is surely coming.

As has been said David, if you can't spend it, then you don't have it! Furthermore, today's market is pricing many assets well below existing debt, hence principal reduction did not result in equity build up. Any reasonable time value analysis takes equity build up and appreciation into account at the end of a holding period when disposition is assumed to occur. As Chris has put it rather strongly, it improperly pumps up the current yield - period!
Joel R. Stryker, Jr. CCIM

There is a simple answer: the Seller or Broker is puffing up the yield! When the real cash on cash return is low, espeically with a seasoned mortgage that has substantial principal reduction, adding the principal reduction makes the deal look more attractive to a "less than sophisticated" prospective Buyer.

Biff has it spot on. Brokers with weak yields use "total return" or some lame derivative thereof to entice people who don't understand the difference into buying their property. MASSIVE waste of time and energy, and a SERIOUS disservice to the cleints on all sides of the transaction.

I agree wholeheartedly with Biff and others in this answer. The broker is puffing the yield to make the product look better than it actually is. Cash on cash is a simple calculation and should be left that way. Part of the reason we're in this interesting time is due to all of the fallacious assumptions plugged into IRR calculations, terminal cap rate assumptions and a failure to use historical norms as a benchmark for valuations.

I have asked this question for many years and got the same answers then that we have seen today. However, as a Broker and Investor I don't see any reason that we can use the debt service number to add back to the cash on cash return.. I certainly factor that number in when I purchase property.. I will be there in the end.

Although it may seem that the broker is "puffing", it is not the true cash on cash return but another way of say the real bottom line. In other words it is the return beyond the cash on cash showing the return after principal reduction.

Gentlemen:
I do not wish to get into this controversary, however you are missing a significant item call "reserve account" which in many investment property loans are specified.
The significance of the Reserve Account (as you are all probably well aware) is for Capital Improvements, Repairs and Maintenance and available for Management's draw/replacement. These may not necessarily be an expensed item but a definite draw on NOI.
Harvey M. Jacobson, MBA/CEO
Commercial Division
Keller Williams Realty - MarketPlace]
2230 Corporate Circle, Suite 250
Henderson, NV 89074
702-939-2000

Does anyone have a simple spreadsheet that can help us doing our own calculation and find out the REAL IRR, NOI, etc as opposed to relying on the broker's yield information?

David,
Net Operating Income (NOI) is simply the Rental Income less everyday operating expenses of a real estate investment. You should evaluate your investments both before and after the effects of your financing. You may find that an investment that has an acceptable rate of return before financing has an unacceptable rate of return after financing due to today's tough lending environment. As others have mentioned you should also factor in future property appreciation or depreciation(!), your tax situation and depreciation of the asset for tax purposes.
You may want to invest in a good text book such as "Investment Anaylysis For Real Estate Decisions" by Kolbe and Greer or "Commercial Real Estate Analysis and Investments" by Geltner and Miller before so that you gain a better understanding of your investment decision.
Good luck!

Although correctly added back to calculate total yield, principal reduction is not a component of cash-on-cash return as the benefit is not derived until the property is sold or refinanced.

I find the discussion very interesting in questioning the validity of the IRR or any on investment calculations. In most instances the results are fiction due to the fact that most brokers prepare their guess-timates from non validated or fractional financial information. I think we should concentrate on obtaining and validating the financial performance of an investment before we attempt to forcast its financial consequences. In many instances brokers provide insufficient or non-validated information on their listing marketing brochures. How can we provide an accurate
investment forcast utilizing incomplete or non-validated information? We need to get back to the basics before we become a financial analysist. And I question if we, as brokers, should be accepting the liabiity of investment performance forcasting.

Agreed, must separate the principal. I find that Cash on Cash is an accurate way to represent annual yield for an investment property. IRR is sometimes misleading since we can not always count on certain events taking place in the market over a 5 year hold period such as "appreciation" of property and other elements of a deal that we must plug in for IRR, especially in this market place...Agreed... Ron R.

Cash on Cash return is a measure using the NOI /INVESTMENT (investment or income property without debt) a fast means of eliminating unacceptable investment that do not meet the investors requirments. Although other measures are possibly better suited a Cash on Cash review is often a starting point.

You are absolutely correct in that principal reduction should not be part of the cash-on-cash calculation and your view of the IRR is also correct. The effect of taxes is taken into account in the after-tax cash flow line and separate IRR and cash flow numbers are often calcualted on it. Principal reduction is properly reflected in the IRR, not in cash flow.

Cash on Cash is the only way to analysis a purchase of a property. The tax advantages and principal reduction are extras after the sell, which does raise your IRR, but it is foolish to use tax advantages calculating how the property is going to perform on a monthly, yearly basis. Try paying your mortgage and other expenses with your tax savings and principal reduction. I concur it is fluff from brokers that are trying to make the investment look better than it really is.

I think we are complicating a simple proses. Many believe that it is fashionable to use "math" in places that a simple arithmetic will do. It is my opinion that IRRs, CAP RATES, YIELDS are practically GARBAGE, as are effected by many outside factors that no one has control over them and they can also be effected by some ones' wishful projections. Projections historically, have been in their majority wrong because are easily manipulated.They are a form of fortune telling
The only REAL meaningful calculation is the CASH ON CASH RETURN.
Who ever ignored that got ALWAYS in to trouble.
You can take my statements above to the bank.

Adding in principal reduction is puffing the return. If the market defines cash on cash as NOI less debt service, then adding principal reduction back in is misleading. The benefit of principal reduction is taken into account in multi-year cash flow projections where a sale of the asset is assumed. As some have stated, this benefit will show up in IRR calculations which also do not reflect the actual return of the investment as IRR assumes the periodic cash flows are reinvested at the IRR rate. IRR by definition is that discount rate in which periodic cash flows equal the original investment. See FMRR for an alternative to get around this. IRR is a decent measuring stick to compare one investment to another if the equity requirement for both options remain the same. If not, you have to balance the equities for a meaningful IRR comparison.
I'm digressing a bit, but IRR returns on leverage investments that are highly leveraged can be very susceptible to minior changes in assumptions and therefore, sensitivity analysis should be performed on numerous line item (assumptions). A good practice is to break down IRR returns into cash flow componets and the reversionary componets.

I think we are complicating a simple proses. Many believe that it is fashionable to use "math" in places that a simple arithmetic will do. It is my opinion that IRRs, CAP RATES, YIELDS are practically GARBAGE, as are effected by many outside factors that no one has control over them and they can also be effected by some ones' wishful projections. Projections historically, have been in their majority wrong because are easily manipulated.They are a form of fortune telling
The only REAL meaningful calculation is the CASH ON CASH RETURN.
Who ever ignored that got ALWAYS in to trouble.
You can take my statements above to the bank.

Dear Paul S.: Tell a seller involved in a short sale that money previously paid for principal reduction "is yours". It isn’t “cash” if you “can’t get to it”. Owners and agents that engage in such "puffing" do themselves and their clients a disservice by destroying their credibility. If you can rationalize twisting the meaning of the very simple term “cash”, what sneaky games are you playing with the more complex items in the transaction? That is what I and most buyers will think of you.

The use of IRR may be a sound academic approach in determining a true return, but as a broker and an investor I realize that my return on my real estate investment is going to be deterrmined only after I have sold the property. Forward analysis is pure speculation. When considering my personal real estate investing, I look at cash on cash, without principle reduction, and rely on my gut regarding the future rent and value trend of that property.
Jim Morphey
Broker/Investor 37 years

Intentionally,its a cheesy tactic that always comes back to haunt the transaction either through the due diligence period or particularly with underwriting .
Its also possible that the Broker/Seller unintentionally, dont understand and just "plug" it in.
If thats the case ... they should get additional "training"

Also, CCIM Courses have some great study material, the spreadsheets and understanding them are very helpful. The format is rigid and the instructors are top notch and straight to the bone.

Cash on cash return is a snap shot of a one year return. It in not appropriate to incorporate principal reduction into the snap shot return since it has not yet been realized. Now if you plan on selling the property at the end of year 1, then it would be appropriate because you would realize that income during the snap shot period. The better measure of return is the IRR which is a discounted value of the income stream. It takes into account the residual value of the asset at some predetermined time of sale; typically 5, 7 or 10 years. The residual value is figured on the NOI capped value of the trailing year.
Coleman Rector
Broker, Developer, Adjunct Professer of Real Estate Investments at Johns Hopkins Univ.

The only thing you can spend is the cash you can out in your pocket. To include principal reduction assumes that the asset will appreciate and ultimately you'll be able to spend the money. What if it doesn't. The only reason to include it is to inflate the return. During the syndication heyday, you saw principal pay down, assumed appreciation in the underlying asset, value of tax savings (those were the good old days when depreciable lives were realistic), calculations of the growth of the "saved" tax money (as if folks put the cash in a sinking fund) and on and on as part of the yield. Boy did those returns look great Trouble is, the were smoke and mirrors. Jim nailed it...cash on cash and rely on your gut for what to expect in the future.

It's just salesmanship and lets face it, salesmen are not know for their honesty. My advice, understand your numbers (or get help from someone you can trust) and be confident in your own analysis, not the brokers. Great question!

Can we try a simple math problem to help clarify? I want to buy a 100 room limited service hotel for $10M. The Bank will finance $7M at 8% for 30yrs. I will invest $3M of my partners' and my own money. It currently generates $2.5M/yr in revenue. Operating expenses for payroll, maintenance, F&B, utilities, general admin, sales & marketing, franchise/management fees, etc. run about $1.5M/yr. Property and liability insurance, real estate taxes and personal property taxes run $250k per year. So NOI (net operating income) aka NOP (net operating profit) or aka EBITDA (earnings before interest taxes depreciation & amortization) - use whatever name you prefer - is about $750k/yr. But that amount still needs to be diluted a bit more to calculate a true cash on cash return. I like EBITDA because it tells me the other costs I need to net out to see the actual cash I can put in my bank account and/or distribute to investors. Lets first take out the I (interest) and the A (amortization aka principal repayment). The $7M loan at 8% for 30 years requires a monthly principal and interest payment of $51,364 - so $616,368/yr. That will now leave us with only $133,632/yr of cash. We will then have to pay for the T (taxes - specifically income taxes on the profits the hotel generates - remember we already paid the real estate and personal property taxes before calculating EBITDA). The income tax liability calculation will vary based on many factors so lets not get into all the different scenarios of how the hotel is owned - LLC, LLP, C-Corp, etc - or whether the State and Fed both collect income tax, or how "creative" your accountant is with "deductions". Let's just say that for this hotel the total income tax liability will conveniently be $33,632/yr. That leaves us with $100k/yr in net positive cash flow from this operation that can be distributed to investors. Since we invested $3M of our own money in this venture, the cash on cash return (aka ROI - return on investment, or aka ROE - return on equity) is only 3.33%. The D (depreciation) is a non-cash "expense" that should not be factored into the cash on cash return calculation. Some might argue however that you need to set aside some cash as a reserve for replacement / capital improvements fund which will account for the aging/depreciation of the property and will ultimately be money that gets reinvested in the property, so it won't be available to distribute to investors. If its cash that does in fact get set aside for future improvements and does not get distributed to the investors, then its probably appropriate to net it out before calculating the cash on cash return. If we decide that $50k/yr is appropriate to set aside as a reserve for replacement, then the net cash available to distribute to investors is just $50k/yr. Now our cash on cash return is only 1.66%. Ultimately its all about how much cash comes out of the investors' pockets to buy the property, and then how much cash gets put back into their pockets from operating the asset and ultimately selling it. So should we buy this hotel? Not much of a yield at its current operating performance. The question I try to answer is can I improve the operation of the hotel to improve EBITDA...which in turn will improve the net cash available to return to investors, and ultimately will determine what the value of the hotel will be down the road when we decide to sell it. For this particular hotel I believe there is an opportunity to improve its performance. So now I shift my analysis from a one year cash on cash analysis (which right now is not very attractive at 1.66%) to an IRR (internal rate of return) cash flow analysis over the entire projected lifespan of the investment. I'll post this analysis next due to length of this post.

I learned a lot from this discussion. Thank you to all of you! The question and answer format where each answer builds on the previous one is an easy sensible learning method.

Lets all agree on cash on cash return is NOI - debt service, however, the actual cash is directly affected by the financing that is placed on the property. so you can use up your cash flow by spending it on debt service.
Is the investment any better on way or the other???

Continued from previous post....Assume that in the first year we were only able to distribute $50k to investors as detailed in the previous post, and that over the next four years we are able to improve that distribution to $75k in yr2, $125k in yr3 and yr4, and $150k in yr5, and that we used all of our reserves for replacement to keep the hotel and its contents fresh, functional, and competetive, without having to inject any additional capital from our own pockets. We decide that we will sell the hotel at the end of yr5. What amount might we realistically project as an achievable sales price for this hotel 5 years down the road? Most of the time a proforma will assign a cap rate to the latest yearly EBITDA amount to determine what a reasonable terminal value (i.e sale price) might be. For this hotel the yr5 EBITDA projection is going to be $850k...so an improvement of $100k/yr from the current $750k/yr level. Hotels, 5 years from now, may be trading at an 8% cap rate (but maybe more, maybe less...who knows). So $850k/8% = $10,625,000 terminal value. At that time the principal balance still remaining on the $7M mortgage will be $6,655,000 which will be paid off at closing. That leaves $3,970,000 to pay for closing costs, sales commissions, etc - figure about $350k. So the investment group will keep the remaining $3,620,000. So the final cash flow for the investors will be a $3M investment when we purchase the hotel, a $50k return at the end of yr1 from operations, $75k return at the end of yr2, $125k for yr3, $125k for yr4, $150k from operations for yr5, and the $3,620,000 from the sale of the property. If you calculate the IRR for this cash flow (easy to do on a spreadsheet with the IRR function) you will get a 7% IRR (internal rate of return) for your invested capital. The investors will realize a net positive cash flow of $1,145,000 over the projected 5 yr investment lifespan. The question you need to answer next is do you really believe your assumptions will hold true over the lifespan of the investment, and if you are willing to bet they will hold true (or maybe even improve) for a projected 7% internal rate of return over the 5 years on your invested $3M. That's really what you need to determine if an investment is worth the risk....not just a one year cash on cash analysis. The alternative would be to invest the $3M in a "safer" asset. T-bills are usually a safe bet, but you won't get a 7% annual return on them. So what do you do? How do you invest your $3M? The stock market? Mutual Funds? Bernie Madoff? Its always going to be a crap shoot. Your trying to predict what will happen in the future, and although we can formulate "educated" projections, they are still always just going to be "best guesses". I like to say numbers don't lie, but you can make them say just about anything you want them to say. Adjusting (manipulating) your assumptions (guesses) can yield all kinds of wonderful projected returns. The question is will you (and your investors) drink the kool aid your serving up? If anyone reading this has any critique of my analysis please post it...Always interested in new ways of looking at a potential investment.

I certainly agree that if the property goes down in value the equity build up can easily dissappear. Whether it does or not you have paid taxes on it (and yes depreciation may offset some of that) as if you received it. Maybe the best way to look at cash on cash is to calculate it like cap, as if you paid cash? In any event David when you look at an investment do it the way it makes sense to you. You already know that money going to principal may be calculated into a financial proformas, so take it out as you have been doing.

Great question and I read comments as hilarious.
In fairness, it is not merely shameless merchandising on behalf of "Listing Brokers"; but the analytical technique has been verified over the last bunch of years when the actual cash-on-cash was minimal due to the crazy cap rates. Many fellow broker comments sounded a little defensive. While I do agree that a pricincipal reduction is a benefit to an investor, it should not be used to dress up an otherwise inadequate, less attractive investment vehicle. (It should be acknowledged; but it can hardly be characterized as part of the investor return as a comparative analysis.) The disparity between brokers and investors was quite amusing to read at the end of a long day.

Cash on Cash is King! The concern is how much I recieve day one on my money. Money devalues , so a future procjection is just fluff. It make the marketing material look good.
Unless someone knows the future here, today is what matters. Remember all those credit tenants, are they all still such. Cash on cash is a reflection of today not IRR.

Hi Smart Agents and Brokers.
Thanks for your answers and ideas.
Here is my different and easy approach.
CCIM Course Textbook defined -
Cash-on-Cash (yield) is (=)
"1st year cash flow before taxes" divided by "Initial Investment (Down Payment)".
We use "Cash-on-Cash" to determine investment value. I suggest an easy example for you to determine how you value the investment property.
Property Price $1,500,000,
NOI (8%); $120,000
Initial Investment (downpayment); $500,000,
Loan amount; $1,000,000, @ 7% interest,
Amortization Period (2 different to compare) ; 30 years and another case 15 years.
Annual Debt Services (ADS) ; $79,836 ( in case of 30 years), $107,859 (15 years)
Ist year Principal Paid ; $10,158 (30 year Amort) / $39,098 (15 year Amort)
Annual Cash Flow (NOI - ADS); $40,164 (30 year) / $12,141 (15 year)
Cash-on-Cash (without Principal paid) - 8% (30 yr amrt) / 2.4 % ( 15 yr amrt)
(For the same property with same downpayment, both Cash on Cash are different)
Cash Flow with Principal paid ; $50,322 Cash flow ( 30 yr amort) ; $51,239 (15 year)
Cash on Cash (if the principal paid is added to the cash flow; very much same -
10% (30 year amort. ) / 10 % (15 year amort)
Amortization period can be changed by investor's purpose, kinds of properties or lenders. The Cash-on Cash to be used for determining investment value should remain unchanged for the same property and with same amount of downpayment. This is my opinion and answer.
Bon Park, Associate Broker, BH&G RE, Executive. Bellevue, Washington

I agree with you that adding back the principal reduction into the equation to calculate cash on cash yield could be misleading when it is added back to the NOI.
The way I look at principal reduction I see it as additional capital added to the initial amount invested when the property was purchased.
For an example let's say I purchased a property for $100,000 and I invest $20,000 as down payment and obtain a loan in the amount of $80,000, and let's say that my debt service including principal and interest for the first year was $9,000 ( $1,000 principal and $8,000 interest). Now, I will deduct the $8,000 interest along with the other operating expenses from the gross income to calculate the NOI, and I will add the $1,000 to the initial $20,000 making my cash investment $21,000, so this way I get a more realistic cash-on-cash rate of return, which actually is lower than what most brokers present it to be.
This is my personal opinion, I don't know if this is the right or wrong way to calculate cash-on-cash yield, but I feel that it gives me a more realistic figure for the return on my investment.

Probably because payments on principal reflect an increase in equity and share
valu even though it is not reflected in cash available for distribution.
cheers,
steve

It is income, so should be counted, however it is misleading a bit, and perhaps should be qualified to show Cash Flow return, and a seperate Income return.

Good question! As professionals we should stick to the textbook formulas in our advertising. As was eluded to in other answers, if a proforma uses a mature mortgage with the principle portion of the payment showing up as cash it will dramatically inflate the cash on cash return. This of course begs the question, can the buyer assume the advertised debt with the advertised terms?
With that said my customers, their acountants, and sometimes even their attorneys jump in with opinions as to what number goes into which collum. I'll stick to the book in my advertising and cull the junk for my buyers.

Gee guys, talk about opening up a law suit. Real estate 101 - never put yourself in a position to get sued based on "legal" or financial information you provide a buyer or seller. Beyond a simple cash/cash return, refer them to their CPA or a real estate attorney (particularly in sue happy CA). Remember the KISS slogan (keep it simple stupid). There are too many unknowns and variables based on what situation a buyer or seller may have with previous, or other, investments that could come forward to the subject property that could have an effect on a buyer or a seller. That you have tthe knowledge to run the numbers is great, but many individual buyers are not sophisticated enough to understand beyond a simple cash/cash (and, even at that point should be advised to see a specialist in accounting or an attorney), and large companies purchasing investments have their own investment team which includes accountants and attornies, so they don't need a broker's calculations. So, bottom line, a broker should not advise a buyer or seller beyond what real estate law allows, regardless of the "expert" knowledge the broker may have. It is fine to do the numbers to satisfy yourself as to what the investment bottom line is, and based on the answers to David's questions, there are many different opinions as to what constitutes "bottom line", some using "fuzzy" math. Just remember - if somewhere down the road a buyer or seller, regardless of what causes an investment not to perform the way the buyer thinks it should, the first person blamed is the real estate broker.