Making money is the ultimate goal of real estate investors investing in rental properties. While different forms of benefits exist, such as appreciation and tax deductions, there’s no doubt that most real estate investors are in search for rental income. When it comes to finding out how profitable investment properties are, real estate investors use what’s known as the rate of return and the main variations of its real estate metrics.
What Rate of Return Is
Don’t let the name throw you off. Rate of return is simply another term for return on investment, which most investors are likely more familiar with. Either way, the rate of return (ROR) and return on investment (ROI) have the same purpose. The rate of return expresses the profitability of investment properties, with expenses considered, over a period of time. This definition helps us come up with the following formula:
ROR = (Annual Rental Income – Costs and Expenses)/Cost of Property × 100% = ROI
The return on investment showcases how profitable a property is. If the property is indeed profitable, it’s ROR will be positive. If, on the opposite side of things, the property consumes more income than it produces, its ROR will be negative.
The Big Three of Rate of Return
The conventional ROR calculation is very useful, but it can be too general in some instances. As a result, three different ROR real estate metrics are more commonly used than the standard return on investment formula. These metrics are actually derivations of the original ROI formula, so the same goal of expressing profitability remains consistent. The three key real estate metrics of ROR are cash flow, cap rate, and cash on cash return.
Cash flow is the most fundamental of all real estate metrics. This measurement is so common that it (or a derivation of it) is used in all other meaningful return on investment calculations.
What exactly is cash flow? Cash flow is the difference between the rental income of a property and its rental expenses.
Cash Flow = Total Rental Income – Total Rental Expenses
The cash flow calculation is simple enough to do manually. It can be used for any time period, whether it’s a week, a month, or a year. Unless stated otherwise, cash flow is always a net value. In other words, cash flow considers the difference in rental income and rental expenses once taxes are taken into account.
Let’s break down the variables of cash flow. Rental income is pretty straightforward; it is the amount of income generated by renting out investment properties. The sum of rental expenses of a property is easy to understand as well. The total rental expenses of a property include operating expenses (expenses used to allow the property to function, such as maintenance and repairs) and financing expenses (such as mortgage payments).
Without a doubt, real estate investors should aim for positive cash flow. The opposite, or negative cash flow, results in properties that are not making money.
Let’s test what you’ve learned from the previous section. What would the annual cash flow of a property be if it generates $1,200 in monthly rental income, costs $520 in operating expenses for the year, and requires $900 in monthly mortgage payments? Would the investor have positive cash flow?
Cash flow = ($1,200 x 12 months) – ($520 + $900 x 12 months) = $3,080
The property would have positive cash flow, and the investor would be making money.
Cash flow is a very helpful metric to use when you invest in real estate, but it is not the only one to rely on. Cash flow does not measure profitability on the price of an investment. The next rate of return metric, called the capitalization rate, does just that.
Cap rate is defined as the ratio of a property’s net operating income (NOI) to its price (or fair market value, FMV).
Cap Rate = NOI/Property Price or FMV × 100%
Let’s break down the variables of this rate of return metric. The property price (or FMV) is exactly as it sounds, no complications there. Net operating income (NOI) is the difference between the rental income of a property and its operating expenses. It is a derivation of cash flow, expect that it excludes financing costs.
Why is net operating income used instead of cash flow in the cap rate formula? The reason is that cap rate estimates profitability of investment properties regardless of their financing methods. If a financing expense, such as mortgage payments, is included in the calculation, the profitability will most definitely change as a result.
An investor wants to invest in real estate and wants to calculate the estimated cap rate of a property. The property’s price is $200,000. It’s estimated monthly rental income is $3,500 and it takes $200 to operate in that time. What is its cap rate?
Cap Rate = ($3,500 – $200)/$200,000 × 100% = 1.65%
Cash on Cash Return
When wanting to invest in real estate through a mortgage, a certain rate of return metric will be of specific value to real estate investors. That metric is called the cash on cash return, or CoC for short.
Cash on cash return is the ratio of before-tax cash flow (BTCF) to the amount of cash invested in a property.
Cash on Cash Return = BTCF /Total Cash Invested × 100%
CoC is similar to cap rate, except that it considers how a property is financed. By using before-tax cash flow instead of just net operating income, mortgage payments are included in the calculation. Interest payments are also included, as BTCF is the difference between the net operating income of a property and its debt service. Cash on cash return also considers the value or the price of a property that the investor owns in a certain point in time by using the total cash invested.
If BTCF of a property is $3,000 and the total cash invested in the property is $150,000, what is the CoC of the property?
CoC = $3,000 /$150,000 x 100% = 2%
Where to Find and Calculate the Rate of Return on Investment Properties
The three rate of return real estate metrics are significant for real estate investors to use and understand. While some calculations are simple to do by hand, using a rental property calculator is the quickest way to compute the metrics. A smart rental property calculator, such as Mashvisor’s rental property calculator, also obtains the data necessary to calculate the metrics. If you want to invest in real estate and succeed, using Mashvisor’s calculator is the only step you need to take!