Equity Based Services, Inc

by Troy Downing

I’ve been asked a few times lately about the differences between cash flow, cash on cash returns, and total returns in Commercial Real Estate transactions. In other words, there seems to be confusion about what the difference on a pro forma is between a 9%/year cash flow distribution and a 25%/year total cash on cash return. There also seems to be some confusion on what the basis is that these are calculated on.

“Cash on Cash” return is a metric that I personally prefer using because it is a simple way of describing the actual return on investment received without weighting the return as principal is returned. This would be much more complicated and would be represented as an Internal Rate of Return (IRR) calculation. An IRR calculation takes into account the time/value of money. I will discuss IRR calculations later, but, for now, it is beyond the scope of this article.

Annual Cash Flow

The Annual Cash Flow is the Net Operating Income (NOI) that is generated and distributed in a year. This does not directly correlate to an investor’s pro rata share of the profit and loss from running the business but rather the amount of cash that is distributed- the free cash flow. The reason that there isn’t a direct correlation between the cash flow and the profits of the business is due to the tax deductible expenses of running the business such as interest expense and depreciation. The basis that the return is based on is the number of dollars that were actually invested into the project.
For example, an investment of $100,000 that pays 9% in cash flow will obviously pay $9,000 over the course of a year. Depending on the project, the investor’s share of profit and loss of the business may only be $2,000 if adequate expenses and depreciation exist to shelter the bulk of the income. So, in our hypothetical situation, the investor receives $9,000 in cash flow distributions but is only required to report the unsheltered amount of $2,000 on their taxes.

If there is no appreciation in the value of the underlying asset or it is never sold at a profit, the annual cash flow and the total return is the same. In other words, if the project is bought for $100,000, it produces $9,000 per year for 5 years and is then sold for $100,000 the total return is 9%/year.

Total Returns with Appreciation

Here’s where the confusion normally sets in. If there is a project that has a pro forma expectation of 9%/year in cash flow and a total return or “all-in” return of 23%/year, what does that mean?

Let’s go back to our earlier example. We will assume that there was a $100,000 investment, it distributes net cash flow of $9,000/year, and it is held for 5 years. With these assumptions, there must be appreciation in the underlying asset. More specifically, it must appreciate by an average of $14,000 per year. (This appreciation is not necessarily linear and may increase more toward the end of the investment cycle than it does toward the beginning.) So, in this example the property must be sold for $170,000 at the end of the 5 year hold.

To calculate the total return, we first add the cash flow received over the 5 year term of the investment. Since we had a simple return of $9,000, we come up with total cash flow of $45,000 distributed over 5 years. Now we add in the appreciation. If we bought in for $100,000 and sold for $170,000 our appreciation is $70,000. Add the total cash flow to the total appreciation and we come up with $115,000. That was the total dollar amount of the return on investment. If we divide this number by the number of dollars invested ($115k/$100k) we end up with a return of 115%. Not a bad return. Now divide the 115% by the number of years held, or 5 in this case, and we end up with a total return of 23%/year.

In other words: total return = ((cash flow + appreciation)/dollars invested) / years held

Total Returns with Return of Principal

Here’s a slightly more complicated model. Some times during the investment cycle, part of the invested capital is returned. Since this is a return of capital, it is not a taxable distribution. But, it does reduce the amount of capital that is “working” in the investment. These returns are normally the result of refinancing that lever properties as they mature. This is a pretty powerful tool that allows the investor to re-invest capital that is freed up from the refinancing and potentially achieve compounded returns as the capital returned is invested.

In this case, the annual returns need to be based on the actual capital in the deal. This is normally represented as a weighted average. An example of a weighted average can be as simple as this: Assume $100,000 is invested for 6 years. At the end of 3 years, $50,000 is returned to the investor as the result of a refinancing. At the end of the term, the remaining $50k is returned. In this example, there was $100k working for 3 years and then $50k working for 3 years. If you add the amount of capital working each year together and divide it by the number of years, you get the average. So, 3 years at $100k = $300k. Three years at $50k = $150k. If you add these together, you get $450k. Divide this by 6 years and you get $75,000 as the average. (100 +100 + 100 + 50 + 50 + 50 = 450; 450 / 6 = 75)

In calculating cash flow rates for an investment like this, the cash flow will always be in relation to the amount invested at a given time. So, if we receive $9,000/year through the 6 years of this hypothetical investment, the return will be 9% for the first 3 years ($9k/$100k) and will be 18% for the second 3 years ($9k/$50k).

It is because of this change in actual equity in the project that you will normally see cash flow percentage numbers move up after a refinancing.

For calculating the total return for a project that returns interim capital, we use the same formula as we did for calculating the simple “all-in” example above, but, we divide the total return dollars by the average equity in the deal rather than the initial investment.

Let’s assume $100,000 is invested for 6 years now. We’ll assume that the investment pays $9,000/year and is sold for $150,000. After 3 years, $50,000 of principal is returned to the investor, so, the average equity invested over 6 years is $75k ((3 * 100k + 3 * 50k) / 6). If we add the cash flow to the appreciation we come up with $104k ($50k appreciation + $54k cash flow). If we divide the $104k by the average principal in the deal ($104k / $75k) we come up with a ratio of 1.38. If we divide this ratio by the number of years held, we come up with a total return of 23%/year. Another way to think of this is that you made 9%/year on the original $100k before the return of capital and you made 34%/year on the remaining $50k. Normally this is simply stated as a 23%/year total cash on cash return. But in any case, you invested $100k and you increased it to $204k over a 6 year period. This is not accounting for the compound returns that you may have generated by investing the $50k return of capital at the midterm of this investment.

In Summary

Annual Cash flow is exactly that. It us usually represented as an annual percentage that an investor receives based on the dollars invested. Total cash on cash return is the total amount of cash flow, plus the total amount of appreciation divided by the amount invested, and then divided by the number of years that the investment lasted. Finally, total cash on cash return with a return of capital is represented by the total cash flow added to the appreciation then divided by the average amount of equity in the deal and then divided by the number of years held.