A successful business is associated with accurate calculations. Therefore, in the real estate investing business, what is a return on investment? Why is it important and what other measures come with it?
What is the Return on Investment in Real Estate Investing?
A return on investment is a measure in real estate investing used to evaluate the annual performance of an investment property. Therefore, it is one of the most important measures that you, as a real estate investor will have to deal with.
The Return on Investment Formula
The return on investment formula is very straightforward. You basically divide the net profit by the net asset worth. For example, if your annual net profit is $50,000 and your asset is worth $200,000, then your ROI is 0.25 or 25%.
What is a Good Return on Investment?
It is really hard to tell, accurately, what is a good return on investment. However, it’s been estimated that a rate of return of 7% and more is a very good measure. Of course, calculating the return on investment depends on other factors as well. For example, many real estate investors choose to fund their investments with mortgages. This leads to higher rates of return on an investment property.
One thing you should be aware of is how risky is your investment. The higher the risk the higher return you need to make sure you are on the safe side. Therefore, the risk is a very important factor that affects the return on investment.
Of course, calculating the return on investment comes with many variables that might be hard for real estate investors to deal with. Especially for someone who doesn’t like math! So, we suggest that you check out the investment property calculator. It analyzes the data you provide to calculate all the related variables and the rate of return as a result.
Now that you know what return on investment is, there are three more figures that you must know. These figures are directly associated with the rate of return of an investment property. They are the capitalization rate, the cash on cash return, and the cash flow. So, let us take a look at what they mean and how do you calculate them:
What is a Cap Rate in Real Estate Investing?
The capitalization rate (cap rate) is a very important real estate investing metric when it comes to estimating the investment potential of a property. Essentially, it is another way to calculate the rate of return on an investment property. So, here are the most important things you need to know about this metric:
The Cap Rate Formula
The cap rate formula in real estate investing is very simple. You calculate the Net Operating Income of your investment property and divide it by its market value. Let’s say your property generates an NOI of $30,000 a year and your property is worth $300,000. By dividing the NOI by the market value of the property you get 0.1 or 10%.
What is a Good Cap Rate?
Well, of course, we cannot tell you what cap rate you should have on an investment property. However, just like the return on investment, there are factors that have a great effect on this measure. The most important ones are location and the real estate market. Moreover, the cap rate is a better measure of commercial real estate as well as longer-term investments. So, if you are wholesaling properties or flipping houses, then this metric is not for you to use.
The Cap Rate Calculator
When calculations get complicated, the cap rate calculator has your back! Calculating the cap rate requires that you know the net operating income which also requires some calculations. However, why bother when you can use one tool that will do it all for you?! As we mentioned before, the results you will get out of the cap rate calculator are affected by several factors. Therefore, your results will vary depending on these factors. For instance, if you are comparing two very similar properties in two different locations, the cap rate might vary. The property that gets the higher cap rate is the one that is in a more profitable location.
What is Cash on Cash Return (CoC return) in Real Estate Investing?
Another real estate metric that is consequential in real estate investing is the cash on cash return. This metric is very similar to the cap rate, however, it only deals with the actual amount of dollars you invest in a property. Therefore, here is what you need to know about it:
The Cash on Cash Return Formula
The cash on cash return formula is very similar to the cap rate formula. However, the only difference is that instead of dividing the net operating income by the property value, you divide it by the total amount of cash you have invested. Let us take the same cap rate example. The NOI is $30,000, the property price is $300,000, but you put a down payment of $50,000 and the rest is covered by a mortgage. So, in this case, you divide $30,000 by the cash you have paid which is $50,000. The cash on cash return, in this case, is 0.6 or 60%.
What is a Good Cash on Cash Return?
As the cash on cash return is a predictive figure in real estate investing, there is no exact figure to determine a good cash on cash return. However, if you take into account the location, the real estate market in addition to the cash you want to invest, you should be able to decide what is a good cash on cash return for yourself. Some house investors won’t buy a rental property that has a CoC return of less than 20%. So, really, it depends on what you are looking for in an investment.
Just as the cap rate, the cash on cash return has its own tool to calculate it. This does not mean that you can’t do it manually. However, why should you bother when you have a tool that saves you time and effort with a high accuracy rate?!
What is Cash Flow in Real Estate Investing?
The cash flow is a very important term in real estate investing. It is basically the part of a rental income that an investor gets to keep for him/herself. Therefore, this makes cash flow a very crucial measure to calculate the return on investment. Here is what you need to know about cash flow:
The Cash Flow Formula
The cash flow formula is, indeed, very basic. essentially, you take the rental income and deduct all the property expenses that are associated with it. However, pay attention to the fact that the cash flow is after you have paid due taxes. Also, if you were to calculate the annual cash flow, then you would have to multiply the rental income by 12 before any deductions.
Positive Cash Flow
Making money in real estate investing = positive cash flow. Therefore, your ultimate goal, as a real estate investor, is to invest in properties that generate positive cash flow. To find out more about positive cash flow and how to find properties that generate this kind of money, then check out our blog “Real Estate Investing 101: What You Need to Know about Positive Cash Flow Real Estate“.
The Rental Property Calculator
For residential real estate investors, the rental property calculator is the best that you can ask for. This tool deals with all the measures related to investing in rental properties. So, before you buy investment properties, make sure you use this tool to analyze the property. For more on this tool, read our blog “What’s the First Thing You Need in Real Estate Investing?: A Rental Property Calculator!“
Now that you know all about the return on investment in real estate investing, we encourage you to check out Mashvisor’s blog. Our blog is one of the best real estate blogs that deal with real estate metrics and evaluation methods. Make sure you subscribe to receive daily topics on real estate and, of course, our latest products.