Cash on cash (CoC) provides an easy way for real estate investors to compare the profitability of similar income-producing properties or gauge it against another investment opportunity quickly.

Cash on cash, however, is not a particularly powerful tool for measuring the profitability of rental income property and currently gets less attention in real estate investment analysis than it used to receive some years ago.

One shortcoming lies in the fact that cash on cash return does not take into account time value of money. Cash-on-cash return must be restricted to simply measuring a residential income property's first year cash flow and not its future year's cash flows.

Nonetheless, cash on cash is not without validity and still offers seasoned and beginning real estate investors a benefit that has always attributed to its popularity.

Cash-on-cash return measures the ratio between anticipated first-year cash flow to the amount of initial cash investment made by the real estate investor to purchase the rental property. Hence, cash on cash is always expressed as a percentage.

The "first-year cash flow" (or annual cash flow) is the amount of money the property is expected to generate during the first year of operation. The "initial investment" (cash invested; sometimes called cost of acquisition) is the total amount of cash invested including down payment, loan points, escrow and title fees, appraisal, and inspection costs.

Okay, let's start with an example and then make the calculation.

Suppose you are interested in purchasing a property with six units that each pays $1,000 per month rent. You estimate the first year's operating expenses to be $28,800. You are planning on a new mortgage with $126,000 down payment, loan points of $2,940, and a monthly payment of $1,956. You estimate that your closing costs (escrow, title, inspections, and appraisal fees) will be $2,100.

Formula: Annual Cash Flow / Cash Investment = Cash on Cash Return

In this case, you would need to make five calculations (to determine Annual Cash Flow and Cash Investment) before you can compute for cash on cash.

1. Annual Rental Income: (6 units x $1,000) x 12 = $72,000

2. Net Operating Income (NOI; income less expenses): $72,000 - 28,800 = $43,200

3. Annual Debt Service (mortgage payment): $1,956 x 12 = $23,472

4. Annual Cash Flow (net operating income less payment): $43,200 - 23,472 = $19,728

5. Cash Investment (down payment + points+ closing costs): $126,000 + 2,940 + 2,100 = $131,040

Calculation: (Annual Cash Flow / Cash Investment = Cash on Cash Return) $19,728 / $131,040 = 15.06%

Now that you know this specific investment opportunity yields a 15.06% cash on cash return, you can compare it to similar properties, or alternative investments such as a T-Bill rate, and decide whether or not to proceed with a purchase.