What is Cash On Cash (COC) return for Minnesota resorts and how does this term relate to valuation?
Unlike the Capitalization (CAP) Rate for resort valuation, the Cash On Cash (COC) return for Minnesota resorts is not nearly as nuanced. The COC return is also called the Equity Dividend Rate. Simply stated, this is the rate of return on an investment measured as the ratio between the cash flow (usually first year) and the initial investment. When you think about COC return, think about your savings account. You put a certain amount of money in an account and the bank gives you a return based upon an interest rate. This interest rate would be considered your COC return.
Savings accounts don’t have a great COC return, but they are safe and they don’t require any work. There are numerous other investment vehicles. Dividend stocks have a return but your COC return is more risky because it is based upon a single company’s performance. Most small cap growth stocks would measure their COC return based upon the appreciation of their stock, the same with large cap stocks, the same with non-dividend mutual funds or exchange traded funds. For obvious reasons, we won’t cover all the possible investments, nor will we speculate on what the COC return is going to be for these vehicles. Investment advisers can give you historical information and will help advise what risk is associated with various investments. Everyone chooses the risk they are interested in taking and unlike resorts, they don’t take any physical effort.
Why is the Cash On Cash return for Minnesota resorts important?
Resorts are BOTH a lifestyle AND a long term investment. When comparing the COC return for resorts, buyers weigh the opportunity cost of their downpayment money versus the other investment vehicles available. Yes, there is a lifestyle component, but their is also a financial component. Before most buyers even look at a resort, they want to know what the resort’s COC return is and what the long term investment opportunity is. They will weigh these factors versus the lifestyle component. They will also include the value of “free” housing and other business expenses that can be managed based upon various cash flow constraints and tax considerations.
How is COC different from the CAP rate?
As a quick reminder, the Capitalization Rate = (Resort Sales Price)/(Net Operating Income). This formula does not take into account the downpayment amount, the mortgage (or mortgages’) terms, the depreciation, nor the tax situation of the buyer. This is where the COC return comes in.
Let’s look at an example of a resort and how the BEFORE tax COC would be calculated.
*Suppose a resort is selling for $4M.
Commercial loans are not done for less than 20% of the sales price and it could be higher if the bank thinks the buyer or the resort is more “risky”. For analysis purposes, let’s assume the downpayment is 20% of $4M or $800K. This $800K is the initial investment amount.
*If the remaining balance of the purchase amount ($3.2M) is financed at 4.25% for 20 years, the yearly mortgage amount would be $240,703.
*If the CAP rate is 10%, the Net Operating Income would be $400K. This means the before tax cash flow is $400,000-240,703 = $159,297. Therefore, the BEFORE tax COC return is $159,297 divided by $800,000 or 19.9%. That number looks pretty good doesn’t it? As a reference, $800,000 invested at 5% is $40,000. When buyers look at this number, they will look carefully at what seller discretionary expenses are included to determine the Net Operating Income . In particular, they will be looking at the wages included for all employees, the income taxes they will need to pay and the capital improvements that need to be made.
More sophisticated buyers will want to know what the AFTER tax COC return is.
One of the advantages of resort ownership are the business expenses that can be written off against the net operating income. From an amortization schedule, you can see that the first year interest on the $3.2M loan is $136,000 which you get to write off. Let’s also assume that the entire $4M purchase price is allocated to buildings – this is not typical, but you need to make an assumption to complete the analysis. This means that the yearly depreciation is $101,265 ($4M divided by 39.5 years). Therefore, your total taxable income in the first year would be $400,000 – $101,265 – $136,000 = $162,735. The the 2020 Federal Tax on $162,735 is $41,057. Therefore your AFTER tax COC is ($159,297 – $41,057) divided by $800,000 is 14.78%. Another good number!
You can’t really compare before tax COC to after tax COC, but sellers should realize the important factors that buyers are looking at. Buyers may wish to figure out a “management salary” and deduct this from the after tax or before tax cash flow to determine a return that is equivalent to other investment vehicles.
If you are thinking about buying a resort, let Lake Country Resort Sales help you find the right resort for you based upon your needs. If you are thinking about selling, let us help you determine a reasonable selling price for your resort. Maybe you are not ready to sell right now, but you need some Exit Planning to help maximize your return. We are here to help. It is never too early to start planning.
-David Moe, Broker/Owner