Real estate has the reputation as a “good investment.” But how good? Better than stocks? Bonds? Gold?
The answer is always “it depends.” If you buy the right property at the right time, real estate investments can run circles around those other investment vehicles. Buy the wrong property at the wrong time, and you may have been better off investing in a hot stock.
The bottom line is, whenever you invest in anything, it is crucial to understand your return on investment (ROI). This includes:
- Making an educated guess of what you think the ROI will be (with the understanding that nothing is certain and every investment involves risk).
- Keeping track of what your actual returns are after you buy and the investment progresses.
When done well, every real estate investment produces income. Discovering its income potential is crucial to calculating your ROI.
Residential or commercial properties held for long periods of time have the potential to generate income by being rented out to tenants. When calculating this kind of income, make sure to take into account:
- The monthly rent itself, set forth in a written agreement called a lease.
- Any recurring monthly fees other than the rent. These could include pet rent, utility reimbursement, parking space rent, storage space rent, and “triple-net” lease rent (a portion of the property taxes and insurance paid by commercial tenants).
- One-time or occasional fees. These could include pet fees, administrative fees, and late fees.
How do you determine how much rental income a property could generate? The best way is to discover what similar properties are renting for. You can find this out by:
- Checking Craigslist, Zillow, the MLS, or other rental listing platforms online.
- Checking the prices listed on property management or complex websites.
- Calling the competition and asking what their rental rates are.
- Asking the opinion of a property manager.
When doing a rental analysis yourself, try to find comparable properties. Property is often given a letter grade: A (new and sparkly); B (a little dated, but still classy); C (dated and maybe a little worse for wear); and D (usually a C that needs a lot of love or might be beyond hope). Try to compare your target property to other properties of similar age and quality.
Rental rates also respond to square feet. Try to compare rental units of the same size. Note that a house that is twice the size of another house will command more rent … but not necessarily twice the rent. After all, it probably doesn’t have twice the refrigerators.
A smart rental property owner factors in a vacancy rate, on the assumption that the property won’t be occupied 100% of the time. They might calculate a non-revenue-earning vacancy period of between 5% and 15% of the year, depending on the type of property.
In addition to rental income, real estate investors usually hope the property will appreciate in value … that is, command a higher price years from now than it does today. This could happen due to market forces or property improvements.
Of course, the further into the future you project, the harder it is to accurately predict what property will be worth. If property appreciates at a somewhat predictable rate in the neighborhood (say, 3% per year), you might as well use that number to calculate your resale value. It’s as good a number as anything.
Of course, if your real estate market corrects or declines, those numbers go out the window. It could take years to get back to breakeven. That’s why after a correction or decline is one of the best times to buy property.
When purchasing commercial property or an apartment complex, the value is probably determined by the income method, not the sales comp method. This method uses a multiplier called a cap rate. If you plan to rehab the property and increase the rent, use this future rent and the current cap rate to estimate the sale proceeds … but again, if the market corrects or declines, cap rates could go up, making your property less valuable.
When flipping a property, sales proceeds are often the only income. You don’t need to calculate rental income … but you do need to calculate expenses. You will incur insurance, tax, utility, and other expenses as long as your flip rehab is underway. Don’t skip that step! You will also need to calculate an ARV (after-repair value) to estimate your sales proceeds.
IMPORTANT: You won’t pocket every dollar of the sale price as sale proceeds. There are always expenses incurred in selling a property, including closing costs, broker fees, last-minute repairs or concessions, etc. Reduce your sale price by 3%-6% if you want to be realistic about what you will pocket after the sale. Sale proceeds will also need to settle any existing mortgages.
Real estate doesn’t just generate income—it also incurs expenses. In successful real estate investments, the income outweighs the expenses so that you make money instead of losing it.
It’s important to track expenses as the investment progresses … but also to make an educated guess of what they might be, before you buy. In the industry, this is called “underwriting.”
Here are expenses you need to account for:
- Rehab. Flips and rentals often require rehab. “Rehab Cost Calculator” worksheets are available, but if you are new to this, the opinion of a trusted contractor or property manager may help.
- Property Taxes. Note that taxes often get assessed higher at the time of sale … but they can be protested.
- Property Insurance.
- Repairs and Maintenance.
- Capital Expenditures—rare, large repairs like a new roof or HVAC. Budget a small amount each month to save for these.
- Contract Services—lawn care, dumpster rental, etc.
- Management Fees.
- Marketing Fees (to find tenants).
- Payroll for on-site staff.
- Mortgage Debt Service (NOTE: this expense is not included in calculations for NOI and cap rate calculations!)
How much do you budget for each of these expenses? That’s the $10 million question. “Rule-of-thumb” expense calculators are available. Make sure to consider the grade of property—for example, an “A” property will probably require less maintenance than a “C” property. A property manager may be able to help fill in some numbers for you.
Now that you know (or have an educated guess) of your income and expenses, we can turn our attention to the return on investment (ROI) and estimate how much money we make.
How do we calculate this? There are a few approaches ...
Return on Cost
“Return on cost” (ROC) considers every dollar spent on acquiring the property and weighs it against every dollar earned. It’s one of the simplest ways to determine real estate ROI and takes into account both rental sales proceeds, and the total rental income over the life of the investment.
Here’s the calculation:
ROC = (Sale Proceeds + All Rental Income - All Expenses) ÷ (Down Payment + Closing Costs + Rehab Cost)
Note that you are dividing every dollar earned by every dollar you put into the project, including the down payment, closing costs, and rehab costs. Mortgage payments do count as an expense in this calculation. You only leave off mortgage payments in cap rate calculations.
Let’s do an example. Say you purchase a property and rent it out for five years.
Down Payment: $50,000
Closing Costs: $3,000
Rehab Cost: $20,000
Sale Proceeds: $95,000
Rental Income Over 5 Years: $60,000
Expenses Over 5 Years: $45,000
Now we just plug these figures into the equation:
($95,000 + $60,000 - $50,000) ÷ ($50,000 + $3,000 + $20,000) = 1.44 or 144%
Your “return on cost” for this investment was 144%. You could also divide that ROC by the number of years for an annualized ROC, also called the “annual average return” (AAR). In this case, divide 144% by five years, and we get 29% ROI per year. Not bad!
Some investors prefer to look at their ROI as a multiple of their initial investment. For example, if they doubled their investment, the equity multiple is 2x.
If you know your ROC, it’s easy to calculate the equity multiple. Just add 1 and an x. In the example above:
1.44 + 1 = 2.44
In our example, you made 2.44x on your money.
Cash-on-cash return expresses cash flow (income minus expenses) as a percentage of the cash invested. It doesn’t take into account sale proceeds.
Here’s the math:
Cash-on-Cash = Annual Cash Flow ÷ Acquisition Cost
In the above example, rental income was $60,000 over five years, but expenses were $45,000. So the total cash flow was $15,000 over five years, or $3,000 per year. The acquisition costs include the down payment, closing costs, and rehab costs.
$3,000 ÷ ($50,000 + $3,000 + $20,000) = 0.041 or 4.1%
This investment made an excellent overall return, but that was mostly due to the sales proceeds. On a cash-on-cash return basis, the investor only yielded 4.1% per year. Better than losing money, but nothing the investor couldn’t achieve with stocks and bonds.
Internal Rate of Return
Investors who purchase different kinds of businesses often want to know the internal rate of return (IRR). This allows them to compare their return on a real estate investment to the return of other kinds of investments they might buy, like stock in a company.
IRR is an annualized percentage yield, like the AAR, but unlike AAR it takes into account the time value of money, to wit money later is worth less than money now due to opportunity cost.
This is a big deal in real estate, since a lot of the money comes later, at resale. Although the ROC might look great compared to a stock, the IRR might not look as appealing.
IRR calculation is very complicated math compared to other ROI calculations. You are better off using an IRR calculator or a spreadsheet app like MS Excel, Apple Numbers, or Google Sheets.
In the case of the above example, the IRR is 9.1%. Not bad, but a far cry from the 29% AAR.