When it comes to real estate investing, the question that is asked by most real estate investors is, “How to measure the performance of my real estate investment?”, or “What is the rate of return of my real estate investment?”. Measuring the return on investment is crucial to assess the performance of real estate investments by giving real estate investors an idea of how much profit should be foreseen in the future, or when comparing the performance of different real estate investments.
Knowing the rate of return of a real estate investment is very advantageous to investors. After all, how would you know if your investment decision was a wise choice? Calculating the rate of return in real estate investing provides investors with important information that can be used to assess the profitability of the investment as well as to improve your decision-making skills and enhance the management and monitoring of your investments. Therefore, knowing how to measure rate of return is a must in real estate investing and one of the basics needed to become a successful real estate investor.
What is rate of return in real estate investing?
The rate of return on investment is the amount of money received after the initial cost of investment, which is often measured in the form of a percentage. If the percentage is positive, then a profit or gain is achieved, while a negative percentage indicates loss. In real estate terms, rate of return is the return on investment after deduction of property related costs such as taxes, mortgage payments, operating costs, etc.
Rate of return (ROR) is basically the same as return on investment (ROI). However, rate of return is measured over a period of time, which is most often annually, while ROI does not necessarily have a time period associated with it because it can be expressed as the return per dollar invested.
In simple mathematics, rate of return can be calculated as following:
Rate of return formula = (Current investment value – Original investment value)/Original investment value) x 100
For example, let’s say that you purchased a real estate property for $300,000. In the next few years the market value of properties in your area increase, and you decide to sell your real estate investment for $350,000. Using the rate of return formula above, the rate of return is calculated as following:
Current value = $350,000
Original value = $300,000
Rate of return = ($350,000 – $300,000)/$300,000) x 100 = 16.67%
Which means that you have made almost 17% of return or profit from your initial investment.
However, measuring the rate of return in real estate investing can get more complicated, depending on the method of financing you choose, and the income that a real estate property generates. The most important types of return are: cash on cash return on investment and total return on investment.
Cash on cash return on investment
The cash on cash return on investment is calculated by dividing the before-tax cash flow (BTCF) by your initial investment.
Cash on cash return = BTCF/Initial cash investment
BTCF is calculated by subtracting your annual mortgage payment from the net operating income of the real estate property. The net operating income (NOI) is the income generated from the property after deducing total expenses. For example, let’s assume your real estate investment has a value of $150,000, and you purchased it with a down payment of $30,000, and the rest is financed by a loan, let’s say a 30-year mortgage fixed at a 4% interest rate (the monthly payment will be around $800, or $9,600 per year). Assume that the NOI generated by the property is $12,000 per year.
BTCF = NOI – Annual mortgage payment
BTCF = $12,000 – $9,600 = $2400
Cash on cash ROI $2,400/$30,000 = 8.0%
The cash on cash return on investment is used by real estate investors to assess their real estate investment’s first year performance. However, its use becomes limited when you want to factor in additional benefits such as the amortization of the mortgage and the future appreciation of real estate value. All these are addressed in the total return on investment.
Total return on investment
Total return on investment (TROI) gives a better and more complete idea of an investment property’s financial performance because it factors in mortgage amortization and appreciation of real estate property over time.
Total ROI = (BTCF + Net sales proceeds – Initial cash investment)/Initial cash investment
Using the same numbers from the example above, assume that after 5 years, you decide to sell the property with an average annual appreciation rate of 4% per year (after 5 years the property would be worth $182,498, and your mortgage balance would be $108,537).
Net sales proceeds = $182,498 – $108,537 = $73,961
BTCF after 5 years = $2,400 x 5 = $12,000
TROI = ($12,000 + $73,691 – $30,000)/$30,000 = 186%
The total return on investment method projects future cash flows and property appreciation; therefore, it is a measure of the potential future gains (or losses) on the initial cash invested.
Another important rate of return in real estate investing is the capitalization rate (cap rate), which is the rate of return on a real estate property based on the income that this property is expected to generate. Cap rate is simply calculated by dividing the property’s net operating income (NOI) by its current market value.
Cap rate = NOI/Current market value
The bottom line
Knowing how to measure the rate of return of a real estate investment is very important if you want to become a successful real estate investor. However, you need to know the different ways that rate of return or return on investment is measured and match it to suitable real estate investments. Finally, remember to use an investment property calculator like the one provided by Mashvisor for your future real estate investments.
For more knowledge on real estate investing, keep reading on Mashvisor.