Blog | Real Estate

How To Use Cash-on-Cash Return and Due Diligence In Real Estate

If you have one but don’t have the other, you’re in for a world of hurt

Summary

• Calculating cash-on-cash return for an investment doesn’t have to be difficult

• Don’t rely on financial models to make an investment decision

• Due diligence is a must when it comes to successful investing

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Many people think that real estate investing is difficult and filled with risk. There are, of course, whole industries that thrive on making simple topics complicated. At Rich Dad, we prefer to make things as simple as possible, a lesson learned from rich dad himself.

And he had a simple formula for real estate success.

Rich dad would always ask two questions:

1. What is the cash-on-cash return for a real estate deal?
2. Have you done your due diligence for a real estate property?

For rich dad, these were two sides of the coin that were essential for moving forward on any deal.

Most people focus on cash-on-cash return, but financial models are only a reflection of what you know in a moment in time. If an investment property cash flow provides a good return on your cash invested, but you don’t do your due diligence, then you run the risk of finding a hidden expense that will blow up your financial models in real life.

As an investor, you don’t have the full story. Due diligence is essential for finding out the full story so you can adjust your financial assumptions as necessary.

How to calculate the cash-on-cash return in real estate

First things first, you never want to buy an investment property that doesn't have cash flow and provide a positive return on the money you’ve invested. It seems obvious, but there are investors that buy investment property using complicated equations such as:

Internal Rate of Return:

This is a return on an investment that assumes all the income (passive/cash flow) you receive is immediately reinvested so that you would be getting a return on that money as well.

Net Present Value:

This takes into account an estimated discounted rate for the future value of money. It takes the value of the money invested today and compares it to the value of the future cash flow at a discounted rate of return.

Each equation has its strengths and weaknesses, and none of them are as straightforward as cash-on-cash return. They rely on estimates, which can create widely varying valuations depending on the quality of the analysis. As the old saying goes, “Garbage in; garbage out.”

While these are important levers for a good investment, the most important lever is simply knowing you’ll make money via cash flow on the money you put in. The best part is that calculating cash-on-cash return is easy.

The cash-on-cash return calculation:

Cash-on-cash return = Positive net cash flow / Down payment

Here’s an example with some sample numbers.

Let’s say you buy an apartment building for $500,000. You put $100,000 down and secure the mortgage for the $400,000 balance.

After all expenses are paid, you have a monthly cash flow of $2,000.

Your cash-on-cash return would be 24%, or $24,000 ($2,000 x 12 months) divided by $100,000.

Depending on your situation, a 24% return could be either good or bad. Only you and your investors can decide that. But understanding your expected rate of return is simple and an easy way to quickly decide if you should move forward or not.

Many successful investors believe that cash-on-cash return is the easiest and surest way to know if a real estate investment is worth their time and money.

The importance of due diligence in real estate

Once you determine whether a real estate investment provides enough cash-on-cash return, it is then essential to make sure you get what you paid for through due diligence.

Due diligence is the process of looking under every crook and cranny of a potential investment. This is a “roll up your sleeves” kind of activity. As part of any contract to purchase, you work a due diligence period into that contract and a clause that requires the seller to provide any and all materials and access requested in a set turnaround time. This includes looking over financials, inspections, rent roll evaluations, and more.

The words “due diligence” are some of the most important words in the world of financial literacy. It is through the process of due diligence (the careful evaluation of a potential investment to confirm all material facts) that a sophisticated investor sees the other side of the coin. Often during a due diligence period, you discover hidden costs that require you to adjust your financial models for cash-on-cash return. This means you can go back to the seller and renegotiate the purchase price to make your models work. If you skip it, you could go quickly from a positive gain to a really bad deal.

Ask any investor how they find good investments, and it’ll almost always have to do with appreciating the process of due diligence.”

Rich dad said, “The faster you are able to do your due diligence on an investment, the better able you will be to find the safest investments with the greatest possibility for cash flow or capital gains.”

The Rich Dad Due Diligence Real Estate Checklist

Rich Dad had a checklist that he always used. Robert Kiyosaki uses one as well. It is very thorough and includes items that did not exist years ago (such as “Phase I Environmental Audit”).

When working through this list, if you have questions about the property, identify experts and bring them in (along with good attorneys and accountants) to review the deal.

1. Current rent roster with paid to dates
2. List of security deposits
3. Mortgage payment information
4. Personal property list
5. Floor plans
6. Insurance policy, agent
7. Maintenance, service agreement
8. Tenant information: leases, ledger cards, applications, smoke detector forms
9. List of vendors and utility companies, including account numbers
10. A statement of structural alterations made to the premises
11. Surveys and engineering documents
12. Commission agreements
13. Rental or listing agreements
14. Easement agreements
15. Development plans, including plans and specifications, and as-built architectural, structural, mechanical, electrical, and civil drawings
16. Governmental permits or zoning restrictions affecting development of the property
17. Management contracts
18. Tax bills and property tax statements
19. Utility bills
20. Cash receipts and disbursements journals pertaining to the property
21. Capital expenditure disbursement records pertaining to the property for the last five years
22. Income-and-expense statements pertaining to the property for two years prior to the submission date
23. Financial statements and state and federal tax returns for the property
24. A termite inspection in form and content reasonably satisfactory to the buyer
25. All other records and documents in Seller’s possession or under Seller’s control which would be necessary or helpful to the ownership, operation, or maintenance of the property
26. Market surveys or studios of the area
27. Construction budget or actuals
28. Tenant profiles or surveys
29. Work-order files
30. Banks statements for two years showing operating account for property
31. Certificate of occupancy
32. Title abstract
33. Copies of all surviving guarantees and warranties
34. Phase I Environmental Audit (if it exists)

In addition to securing everything on this list, take the opportunity to physically walk and inspect the property, including each unit if purchasing an apartment building. Take inventory of all damages and use that inventory list to negotiate a fair price.

In the end, the recipe for real estate success is easy, cash-on-cash return + due diligence. Do those right, and you’ll be in great shape.