Do you want to make successful real estate investments? If yes, which I’m sure was your answer, read on to see which metrics to use in a return on investment analysis.
When it comes to making the best real estate investments, the return on investment analysis is key. I’m sure a couple of you have already heard about the importance of calculating the ROI before investing in a rental property, or any income-producing property. But for those of you who haven’t- it’s pretty important. The return on investment analysis opens the door for any other analysis you might need to conduct. It helps you when you’re comparing real estate comps in a comparative market analysis, also called a real estate market analysis, and in an investment property analysis. Probably the most important number in all of real estate investing is the ROI.
What’s a Return on Investment Analysis?
If you don’t know the answer to this question, you should pay attention-it could really boost your real estate career. The return on investment analysis is the foundation of everything in real estate investing. You invest and take risks because you expect returns. Making money in real estate is all about realizing a profit, making more than what you spent, and knowing when to take the risks. So, conducting a return on investment analysis should be a no-brainer. Let’s first give you the basic definition and then get into the real estate metrics.
You’d conduct a return on investment analysis to get the ROI of a particular investment property. The ROI is a performance measure used to evaluate the efficiency and profitability of a real estate property. It is the amount of return (profit) gained from an investment relative to its cost. To really understand how to make a profit on a real estate investment, you need to balance the risks with the benefits. You can do this by using the internal rate of return (IRR) in real estate investing.
RETURN ON INVESTMENT FORMULA
Return On Investment= (Gain from Investment- Cost of Investment)/ Cost of Investment
So the formula looks simple enough. The gain from investment- cost of investment, simply translates to the net profit-easy. The cost of investment is the price of the property- how much cash you spent to purchase the property. Easy… right? Wrong. You and I know better than to assume that’s all there is to it. There are so many other variables that need to be factored in before simply subtracting and dividing two numbers.
It doesn’t need to be an overwhelming process, however. Mashvisor provides you with a multitude of blogs specifically aimed at the return on investment analysis, along with much more. To read more of our blogs, and learn everything there is to be learned about real estate investing, click here. If you’re interested in ROI calculations and want in-depth examples of different scenarios, check out these blogs:
- How to Calculate Return on Investment for the Most Profitable Real Estate Investments
- How to Calculate Return on Investment in Real Estate: 5 Different Ways
Return on Investment Analysis: The Metrics
#1. THE CAPITALIZATION RATE:
Also known as the cap rate, this metric represents the value of the property in relation to the income it produces. It’s the ratio of the net operating income (NOI) to property asset value.
Cap Rate= NOI/ Market Value
The net operating income is found by deducting the operating expenses from the gross operating income. The rental income (rent collected from your tenants) minus the rental expenses (maintenance, repairs, property tax, etc.) is the NOI for a rental property. A positive NOI means revenues>expenses, which means positive cash flow. The market value of the rental property would be the selling price of the property.
For example, if you’ve invested in a single-family home worth $40,000, and you generate $700 of net monthly rental income, the calculation for cap rate is as follows:
Net operating income= $700 x 12 months= $8,400 annually
Cap Rate= $8,400/$40,000= 0.21
0.21 x 100= 21% (multiply by 100 to get the measure in percentage form)
Basic mathematics and common sense tell us this: The higher the cap rate, the higher the returns, the higher the risk. The lower the cap rate, the higher the market value, and for you, this means the higher the price you could sell it for. A good cap rate differs for each investment property. Factors like location, interest rates, and property type all alter the definition of ‘good cap rate’. You can also use the cap rate to compare similar rental properties. A comparison of the rental comps based on cap rate can give you an idea of the different levels of performance executed by each property.
#2.CASH ON CASH RETURN:
Sometimes referred to as the cash yield on a rental property, the cash on cash return is very important for an ROI analysis.
Cash on Cash Return= Annual Dollar Income/Total Dollar Investment
Cash on cash return only uses the pre-tax inflows and outflows of an investment. It is a ratio of the cash coming in by the property to the cash that you spent on the property. The total dollar investment is the down payment (and additional closing costs and other costs you put upfront) made on the investment property. For more information on cash on cash return, click here.
#3. Price to Rent Ratio
The first two metrics discussed dealt with the profitability and performance of an investment property based on income and market value. Now, we’re going to discuss the ratio that’s used to decide whether to buy or rent a property. What does this mean? The ROI and price-to-rent ratio measure different things. The price-to-rent ratio examines the property price and its rental income. It provides a comparison between owning and renting properties in certain areas.
#4. Gross Rent Multiplier
This final metric is similar to cap rate, in that it analyzes the profitability and value of a property. The difference lies in the values used in each calculation which is in this metric’s name- gross. The cap rate deducts expenses before calculations. However, that’s not the case with the gross rent multiplier (GRM).
GRM= Market Value/Gross Rental Income
GRM is the ratio of the price of a real estate investment to its annual rental income before accounting for expenses such as property taxes, insurance, and utilities; GRM is the number of years the property would take to pay for itself in gross received rent.
Final Word- Return on Investment Analysis
Conducting an ROI analysis is crucial to any successful real estate investment business. It allows you to analyze an investment property based on its value and profitability. Rental income and expenses play an important role in all the real estate metrics mentioned- either directly or indirectly. The ROI analysis answers questions from: ‘Should I rent or buy this property?’ to ‘How much rent should I charge?’ to ‘How valuable is this property in the real estate market?’
If all these formulas and calculations are stressing you out a bit, don’t worry. With Mashvisor, you can utilize our many real estate investment tools which make your life a lot easier. Mashvisor’s investment property calculator quickly and efficiently calculates all the important real estate metrics for you. Read about our rental property calculator here.
To learn more about how we will help you make faster and smarter real estate investment decisions, click here.