Having talked to hundreds of investors each year at Memphis Invest, I have stopped being surprised by the different reasons investors list for purchasing investment property. Often times, the criteria that investors use to determine a"good deal" are as varied as the colors in a box of crayons. As a seasoned investor, I can tell you with authority, that if I had to choose one measure for an investment deal it would be its cash on cash return.
A cash-on-cash return of an investment property, in its simplest form, is a measurement of a properties gross income divided by the amount of cash used to purchase the property. It is important to remember that gross income is before any expenses such as taxes, insurance, management and holding costs. A properties cash on cash return is important to quickly determine if the property will be a profitable investment over time (as long as you have all other costs in front of you).
For a quick assessment of a properties potential, I would use the cash on cash return of a property and, if you are looking at multiple properties to purchase just one, this calculation can narrow your decision. I am quick to caution that is should not be the only barometer when deciding to purchase a property, but can help you weed out the bad investment properties quickly.
Over the years, I have learned that cash on cash returns can vary on a property and will absolutely adjust with the economy. When rental rates are squeezed so is your cashflow and when rental rates rebound, your cash flow and rate of return grow as well. I often tell investors who are focused on things such as the color of the walls and the layout of a property, that financial calculations and the location of a neighborhood are far more important factors to consider and financial calculations should come first when narrowing down the properties you want to purchase.
I am also quick to note that price does not equal value. Since price is taken into account when determining a cash on cash return, make sure to remember that there are many other factors to consider before making a final decision on an investment property.