Real estate investing for beginners comes with unique challenges. One of the more significant ones is determining the profitability of existing or potential real estate investments. How can this challenge be solved? The answer is by calculating the ROI of the investment property!
The ROI, or return on investment, is a valuable metric for all real estate investors. There are three main ways to calculate the ROI of real estate investments. These ‘big three of ROI’ include cash flow, cap rate, and cash on cash return.
Cash flow is the most basic, yet most important, of the ROI metrics. This makes it a must-know in real estate investing for beginners. At its roots, cash flow tells real estate investors whether or not their investment properties are making money.
How to Calculate Cash Flow
Cash flow is defined as the difference between the rental income of an investment property and its rental expenses.
Cash Flow = Total Rental Income – Total Rental Expenses
As you can see from the equation, when the cash flow is positive, i.e., there is more rental income than expenses, an investor receives a net gain. In simpler terms, a real estate investor makes money from real estate investments when cash flow is positive. The opposite is negative cash flow, which puts the investor at a net loss.
When the cash flow of a rental property is compared to its value, the cash-zone formula is used.
Cash-Zone Formula = (Gross Annual Rental Income/Property Price) × 100%
All the factors that matter in the cash flow calculation, such as expenses, income, and property price, are easily obtained with Mashvisor’s investment property calculator. The calculator not only gathers the information with the most accurate data imaginable, but it also calculates the cash flows of properties in no time!
Cash Flow Example
Concepts in real estate investing for beginners are best illustrated with examples. We’ll start with an example of cash flow. If an investment property generates $2,500 in monthly rental income but costs $575 in rental expenses, what is its cash flow?
Cash Flow = $2,500 – $575 = $1,925
This cash flow is nothing but simple math, yet it reveals a lot about the profitability of the property. In our example, the property generates $1,925 in positive cash flow.
What if the property’s purchase price was $350,000? What would its cash flow projection for the year be?
Cash-Zone = [($2,500 × 12 months)/$350,000] × 100% = 8.6%
What Is Considered a Good Cash Flow?
What exactly is considered a good cash flow? Generally speaking, anything that has positive cash flow. The more positive cash flow, the better. A more accurate estimation of good cash flow comes from the cash-zone formula. Real estate investments with a cash-zone percentage of under 8 percent will likely have negative cash flow. A range from 8 to 10 percent, as in our example, indicates good, positive cash flow. Anything higher is obviously better, as a percentage of 10 percent or more will definitely lead to great positive cash flow.
The second of the big three ROI metrics in real estate investing for beginners is the capitalization rate, or cap rate for short. While cap rate is used to measure profitability, as is the case with cash flow, it is more commonly used to compare real estate investments. Nonetheless, it’s an essential for real estate investing for beginners.
How to Calculate Cap Rate
Cap rate is the ratio between a property’s net operating income (NOI) and its property price, or fair market value (FMV).
Cap Rate = (NOI/FMV) × 100%
The capitalization rate formula contains variables that are essential for real estate investing for beginners. One of these variables might sound unfamiliar to beginning real estate investors. Let’s break it down.
The NOI of a property is the difference between the rental income of a property and its operating expenses. Operating expenses include maintenance, management, utilities, and more.
NOI = Rental Income – Operating Expenses
In a way, NOI sounds similar to cash flow. There is, however, a subtle but key difference between the two variables. Cash flow includes operating expenses and financing expenses. NOI only considers operating expenses.
Once again, Mashvisor’s investment property calculator facilitates real estate investing for beginners. Its calculator computes all the variables pertaining to cap rate. Start your trial with Mashvisor to calculate the cap rates of your real estate investments.
Cap Rate Example
The cap rate calculation is a simple one. If a property has a NOI of $40,000, and its FMV is $415,000, its cap rate would be:
Cap Rate = ($40,000/$415,000) × 100% = 9.6%
What Is Considered a Good Cap Rate?
Here’s a bonus piece of information for real estate investing for beginners: the ranges of ‘good’ for ROI metrics tend to be very similar. Like cash flow, a range of 8 to 10 percent of cap rate is considered good. However, it’s worth noting that this range does change based on the real estate market, asset type, and other factors.
Cash on Cash Return
The final ROI metric of real estate investing for beginners we will discuss is cash on cash return, also known as CoC. CoC is similar to cap rate in importance, but not in applicability. CoC is the more common ROI metric.
How to Calculate Cash on Cash Return
The cash on cash return of an investment property is the ratio of the property’s pre-tax cash flow and the total amount of cash invested in the property.
Cash on Cash Return = (Pre-Tax Cash Flow/Total Cash Invested) × 100%
Normally, cash flow is post-taxation, but not in the CoC calculation. The more interesting variable in the calculation, though, is the total cash invested.
When a property is paid for fully in cash, the total cash invested is equal to the purchase price of the property. However, most real estate investors purchase real estate investments through mortgages. In this case, the total cash invested will be equal to the down payment and other mortgage costs. These costs, and many more, can be calculated using Mashvisor’s investment property calculator.
Cash on Cash Return Example
An investment property with an annual pre-tax cash flow of $20,000 with a total cash investment of $150,000 has a CoC of:
Cash on Cash Return = ($20,000/$150,000) x 100% = 13.3%
What Is Considered a Good Cash on Cash Return?
Similar to both cash flow and cap rate, a good cash on cash return is between 8 and 12 percent.
ROI is an essential metric of profitability in real estate investing for beginners. It is of utmost importance for new real estate investors to get comfortable with ROI. To learn more about real estate investing for beginners, start your trial with Mashvisor!