4 Ways Passive Investors Can Calculate ROI In Real Estate
No, it wasn’t much fun but it did make me rethink how I evaluated property, especially the return on investment (ROI).
If you don’t have a good grasp on calculating ROI in real estate then you’re setting yourself up for failure.
Previously, my method of evaluating property involved:
- looking at the pictures of the building
- choosing the property with the highest investment return (but didn’t know about calculating return on any of them)
Fairly sophisticated, right? 🙂
It’s safe to say that people hoping to become profitable via real estate property investing are those that can accurately calculate the property’s ROI before acquiring it.
And being able to perform a ROI calculation is one of the best indicators to do so.
I’m not suggesting you have to become a math genius to be a real estate investor by any means. But you will have to have a general rule of thumb and working knowledge of a few important numerical concepts that we’ll discuss today.
Before we get into specific calculations, let’s discuss what ROI in real estate is.
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What Is ROI in Real Estate?
The return on investment ROI of a rental property is how much money you’ll make on your investment.
It’s the ratio between the profits and costs of an investment that’s usually expressed as a percentage.
Those who know the ROI numbers can make a better decision whether or not to invest.
It’s important to understand what factors can affect a property’s ROI because some of the calculations can be manipulated.
Before we get into real estate, let’s take a look at the ROI equation used to calculate the return with any investment.
Even though determining the ROI is extremely important, one of the calculations used to determine it is actually simple and easy to understand.
You first take the total return on the investment and subtract the original cost of the investment.
Based on the ROI definition, the return on investment formula is as follows:
For example, if you buy Tesla stock for $1,000 and sell it two years later for $1,600, the net profit is:
- $600 ($1,600 – $1,000).
- ROI on the stock is 60% [$600 (net profit) ÷ $1,000 (cost) = 0.60]
This example is easy to understand, especially when dealing with a stock investment. But when attempting to calculate the ROI in real estate, there’s several variables to consider that can affect the numbers.
- leverage on the property
- financing terms
- maintenance costs
Let’s now shift gears and get into the specific metrics used to calculate rental property ROI.
The 4 Types of ROI Calculations
#1 Cash Flow
He claims that he never saves money but instead, invests in assets that pay him “mailbox money” also known as cash flow.
Cash flow is the amount of money left over each month from real estate after paying the operating expenses and putting aside money for future repairs.
Cash flow = gross rental income – expenses
Example of calculating cash flow:
To make this as easy as possible to understand, let’s use an example of Dr. S that is wanting to get into real estate. He feels that he has enough spare time to become a landlord and hires a real estate agent to be on the lookout for him.
A few weeks later, his realtor informs him that he’s found a real estate deal that has the following variables:
Monthly rental income: $1,200
Monthly operating expenses:
- Mortgage: $400
- Property taxes: $220
- Insurance: $50
- Property management fees: $100
- Vacancy reserves: $50
- Repair reserves: $100
Total monthly expenses: $920
Remember that: Cash flow = gross rental income – expenses
Cash flow: $280 [$1,200 (rent) – $920(expenses)]
This means that Dr. S will be receiving $280/month in profit from this rental property.Join the Passive Investors Circle
#2 Cash on Cash Return
The cash on cash return is one of the most popular methods to calculate the ROI in real estate.
It measures your pre-tax cash flow relative to the amount of money you invested to acquire the property.
Here’s how to calculate the cash on cash return:
Cash-on-cash return = annual cash flow / initial cash out of pocket
Using this metric is a quick way to gauge how well a property will perform. It expresses the ratio of annual cash flow to the amount of actual cash you invested upfront.
If we continue using the above example, let’s also assume that Dr. S’s initial cash out of pocket was $35,000 which included:
- down payment
- rehab costs
- closing costs
Monthly cash flow: $280
Annual cash flow: $3,360 ($280 x 12 months)
Initial cash out of pocket: $35,000 (down payment + closing costs + rehab costs)
Cash-on-cash return = 9.6% ($3,360 / $35,000) x 100
3 reasons why you should consider using a cash on cash (CoC) return:
- simple to use – allows potential investors to quickly prescreen investments with a good idea of returns based on the amount invested
- property comparison – allows for rapid way to measure profitability (long-term) on multiple properties at one time.
- expense forecasting – CoC return can help to determine both expected AND unexpected expenses
#3 Cap rate
The cap rate is used in commercial real estate to indicate the rate of return that a property is expected to generate.
It’s based on a ratio of the current income to the market value of the property.
The cap rate is similar to the cash-on-cash return except:
- It doesn’t factor in loan expenses
- It looks at the purchase price instead of the amount of cash you initially invested
When someone says a property has a cap rate of 5%, or that assets in a given area are trading around a 5-cap, they are talking about the potential investment property return.
Cap rate formula:
To calculate the cap rate formula of a property, divide the Net Operating Income (NOI) by the property’s value.
This formula does NOT include a mortgage or interest payment.
Excluding debt is part of why a cap rate is so useful. The formula is focused on the property alone and not the financing used to buy the property.
Cap Rate Example
For our example, Dr. S decides to purchase an apartment complex in his hometown in Louisiana for $1 million. He’s excited that during the first year of ownership, it brought in $100,000 in rental income.
He’s well on his way to financial freedom!
He paid $50,000 in operating expenses the first year which made the net operating income (NOI) equal $50,000
Using the cap rate formula above, we take the NOI and divide it by the total investment for the apartment which gives us a 5% cap rate:
$50,0000 / $1,000,000 = 5%
This means if we bought that property with $1 million dollars today, we could expect to earn $50,000 in net income over the course of one year. This is your Return on Investment or ROI.
One way to think about it is that it’d take 20 years of long term returns at $50,000 to recoup your $1 million initial investment. This does NOT take into account appreciation which more than likely the property would go up in value on average.
If the property generated $150,000 with the same $50,000 in expenses, the cap rate would be $100,000 divided by $1 million, which would equal 10%. In that case, it would only take 10 years to recoup your initial investment value.
The higher the cap rate, the faster you’d earn back your investment capital, and the better the investment choice.
#4 Internal rate of return (IRR)
The internal rate of return (IRR) is one of the most misunderstood metrics regarding calculating the ROI of a property.
It measures the rate of return earned on an investment during a specific time frame in which you own it.
Effectively, the IRR for real estate is the percentage of interest you earn on each dollar you have invested in a property over the entire holding period.
It includes cash flow and any profits from a property’s sale.
Regarding the syndication deals we’re in, it takes into consideration the quarterly distributions we receive during the hold period plus the profit split with the sponsor once it sell.
How sponsors calculate the IRR
In order for a sponsor to calculate a property’s IRR, they use the amount and date of all payments to investors. Unlike cash-on-cash return and equity multiples, the IRR takes into account the time value of money (i.e., $100 today is worth more than $100 in 5 years).
Typically, this calculation includes the ongoing distributions plus profits at sale. If there is a refinance or supplemental loan, those proceeds are included in the IRR calculation.
Calculating a new potential real estate investment takes several factors into consideration.
Once you obtain some of the initial numbers and annual return, you’re now able to make your own calculations to determine whether the property will be a good addition to your real estate portfolio.
If you want more help with developing real estate goals and learning more about what I’m personally investing in, then join the Passive Investors Circle today.Join the Passive Investors Circle