Most serious musicians eventually need to learn music theory. Like studying grammar when learning a language, music theory helps musicians understand how music is structured.

Music consists of some combination of pitch (single sound), horizontal (multiple sounds played in sequences to create a melody), vertical (multiple sounds played simultaneously to create harmony), and rhythmic elements. When combined, two or more of these elements create a unique composition.

Music theory is a framework for describing how those four musical elements combine to create a composition. Music theory also includes studying the rules and conventions of composers from various periods and compositional schools combine the elements. For instance, the harmonies on a Bach composition differ significantly from those in today’s jazz.

Like music theorists, real estate investors also have methods for describing how to value a property. At the most fundamental level, real estate investors are concerned about how much cash they need to invest the property (which I’ll call “cash in”) and how much cash they will receive from the investment (which I’ll call “cash out”).

As with music theory, there are several methods investors use to evaluate profitability. But they all start by looking at cash in and cash out.

This article is part of a series about methods investors use to evaluate investment profitability. This article discusses “cash-on-cash return.”

What is Cash-on-Cash Return?

Cash-on-cash return calculations look at only two numbers: the cash an investor invested in the property and the annual cash the investor receives on the investment. The formula for cash-on-cash return divides the annual cash out (annual cash distributions) by the total cash in (total cash invested in the property):

Cash-on-Cash Return = Annual Cash Out/Total Cash In

Cash-on-cash return usually is expressed as a percent. For instance, if an investor paid $1 million for a property and received $50,000 per year in cash from the investment, the cash-on-cash return would be five percent (5%).

How can Cash-on-Cash Return be Used to Evaluate an Investment?

Cash-on-cash return is helpful for investors focused on the annual income from their investment. A cash-on-cash return evaluation can help investors compare two investments requiring the same cash outlay.

Cash-on-cash return is a reasonable surrogate for investment interest. Therefore, it can help investors compare a real estate investment with other investment types.

Consider this example:

Maria and Jessie are a retired couple who depend upon their investment income to supplement Social Security. They have $1 million in a long-term certificate of deposit that provides only one percent (1%) of interest or $10,000 in cash per year. With their increased living costs, they need at least $30,000 in cash per year from their investment to avoid withdrawing money from their principal. Their investment options are to put $1 million in one of the following:

1. Real estate investment in an apartment building forecasting a 3.5% cash-on-cash return ($35,000) for seven years and return of the $1,000,000 investment upon the sale of the property at the end of year seven.

2. Non-qualified annuity from an AAA-rated insurance company that pays $50,000 per year for 25 years.

3. A $1 million AAA-rated corporate bond that pays 3.5% in interest ($35,000) every year for ten years, with a return of principal at the end of year ten.

4. An $1,000,000 AA-rated tax-exempt bond issued by the state Maria and Jesse live in that pays 3.4% in interest ($34,000) every year for seven years with a returning the principal at the end of year seven.

Looking only at the cash return, Maria and Jessie buy Investment 2 since it will give them the highest annual income, and it guarantees that income for 25 years, much longer than the other investments.

What Cash-on-Cash Return Doesn’t Evaluate

Cash-on-cash return provides a simple way to compare investments and can be useful for investors who need cash income from their investments. However, cash-on-cash return computations disregard several factors that may be important when evaluating an investment, especially when, as in the example above, the cash return from a real estate investment must be compared to cash returns from other investment types.

Cash-on-cash return doesn’t look at tax benefits (or detriments) from investments. And more important, cash-on-cash return doesn’t consider the risk of default during the investment period. A cash-on-cash return also doesn't consider the time value of money, a complicated concept beyond the scope of this article.

Default Risk

In the example above, Investments 2 and 3 (the annuity and corporate bond) are rated AAA, the highest investment rating. So they have the lowest default risk. Investment 4 (the tax-exempt bond) has a strong AA rating, so default risk is also low.

Most real estate investments aren’t rated. That doesn’t necessarily mean that they have a higher default risk than rated investments.

However, the investor needs to closely review the investment's financial forecasts to assess default risk and evaluate whether the underlying assumptions are conservative, aggressive, or somewhere in between. Most investors have neither the experience nor interest in doing a deep dive into the forecasts to make this evaluation.

Based solely upon the risk of default, Investments 2 and 3 are the winners.

Tax Ramifications

Cash-on-cash return doesn’t evaluate the tax benefits (or detriments) of an investment. Suppose Maria and Jessie have a combined federal, state, and local income tax bracket of 30%.

Investment 1 is a real estate investment and will produce depreciation deductions to offset some of Maria and Jessie's cash return. Suppose 10% of the $1,000,000 investment is assigned to land and 90% is assigned to the apartment building. The land isn't depreciable, and multifamily real estate is depreciated over 27.5 years.

In that instance, Maria and Jessie would receive a $32,727.27 depreciation deduction each year, which would reduce their taxable income from the investment. That would save them about $9,818.18 each year in taxes, as they would pay taxes on only $2,272.73 of their cash return for an annual total tax liability of $681.82

Investment 2 is an annuity. Simplifying the calculation, even though Maria and Jessie would receive $50,000 per year, 80% or $40,000 of that cash would be a non-taxable return of a portion of their original investment. That means they would pay taxes on only $10,000 of the cash and have a total tax liability of $3,000.00.

Investment 3 is a corporate bond, so the entire $35,000 Maria and Jessie receive every year would be taxable. They would pay $10,500 on their annual return.

Investment 4 is a tax-exempt bond. Assuming their state doesn’t tax interest on its own bonds, their total income tax liability on Investment 3 would be zero.

Looking solely at tax ramifications, Investment 4 is the winner.

What About Real Estate?

You may have noticed that the real estate investment wasn’t the winner in any of the evaluations in this article. Although cash-on-cash return is frequently used to evaluate real estate investments, it doesn't give a complete picture of the benefits of investing in real estate.

As demonstrated above, with depreciation deductions, real estate investments can provide a legal way to shelter income from taxes. To the extent Section 1031 is available, real estate investors can legally defer taxes on their gains from real estate investments.

Real estate can help investors diversify their portfolios to minimize portfolio risk. And real estate can be a good hedge against inflation.

Real estate also can appreciate in value. So, the biggest advantage to real estate investors is the gain when the property sells, rather than the cash income they receive while they hold the investment.

Cash-on-Cash Doesn’t Give the Entire Picture

Music theory doesn’t just look at the melody or rhythm. It analyzes entire compositions. Investors should do the same.

The examples in this article make basic assumptions to demonstrate the limitations of cash-on-cash return in evaluating investments. Actual investments and tax situations are likely to be more complex, particularly with real estate investments.

Although cash-on-cash returns are easy to calculate and can provide a basis to compare real estate investments to other investment types, that metric doesn’t give the complete picture. And as investments and tax situations become more complex, cash-on-cash returns are less likely to present the complete picture about an investment. For investors who recognize its limitations, a cash-on-cash return analysis can useful, but it is just one tool among the many a prospective investor should use when deciding when to invest.

This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.