Every real estate investor with an investment property NEEDS to be familiar with return on investment (ROI). Why? Well, without ROI, real estate investors cannot tell if their properties are making money relative to the investment. That begs the question: How do you calculate ROI? Through a return on investment formula, of course! But just which formula are you supposed to use? Which return on investment formula is the best?
The ‘Best’ Return on Investment Formula
We need to address the latter question before answering the former. The meaning of ‘best’ will certainly differ from one real estate investor to another. Would the best return on investment formula consider just rental income, or would it include appreciation as well? Would the best return on investment formula take the financing of the income property into account? The answer to these questions, and many more, is that it is situational. Essentially, there is no ‘best’ return on investment formula. Instead, there is a return on investment formula ‘best’ suited for certain situations.
While you can use many ROI formulas for different situations, here are the six most commonly used ones. The situations in which they are best used will be specified.
Return on Investment (ROI)
Our discussion begins with the most common return on investment metric, which is simply the standard return on investment ROI of an investment property.
ROI = (Annual Rental Income – Cost of Investment)/Cost of Investment × 100%
The standard return on investment (ROI), or rate of return (ROR), formula can be very helpful when trying to estimate or calculate the returns of an investment property. The formula computes the positive cash flow of an income property through annual rental income and annual rental expenses. The positive cash flow is then compared to the amount used in the investment. As a result, the higher return on investment property a real estate investor has, the better!
Best Used When: This return on investment formula may be basic, but it gives rise to all the other ROI formulas available. Therefore, this formula is best used to estimate or calculate actual returns and to better understand the concept of a return on investment property.
ROI for Cash Purchases
One of the first modifications of the original return on investment equation arrives when an income property is solely purchased with cash. When this (uncommon) situation arises, the following ROI formula is used:
ROI = (Annual Rental Income – Expenses)/Property Price x 100%
When comparing this formula to the original, it is clear that only one slight modification has been made. The ‘cost of investment’ of an investment property purchased solely in cash is changed to the price of the property. Both are much of the same in this scenario.
Best Used When: This is pretty self-explanatory. This basic type of ROI formula is best used when a real estate investor buys a property only through cash and wants to estimate how it’ll be making money as returns.
Capitalization Rate (Cap Rate)
We move on from one of the least common ROI formulas to one of the most used ones. The cap rate, short for capitalization rate, is a more advanced return on investment formula that compares the net operating income (NOI) of an investment property to its property price or fair market value (FMV).
Cap Rate = NOI/FMV or Property Price x 100%
What cap rate and ROI for cash purchases share is using property price in the denominator. One of their main differences, however, is that the cap rate uses NOI instead of positive cash flow. The latter considers financing investment property expenses, while the former does not.
Best Used When: Cap rate excludes financing expenses, which limits its practicability. However, since it does take financing investment property expenses into account, it provides for a very objective measure for comparison. Therefore, cap rate is best used to determine what is the best real estate investment in terms of returns when comparing properties.
Cash on Cash Return (CoC)
The one area cap rate falls short in is that it does not consider financing investment property fees. The ROI metric known as the cash on cash return (CoC return), however, solves this problem. The cash on cash return of a return on investment property is defined as the ratio of a property’s before-tax cash flow (BTCF) and the total amount of cash invested in the investment property. Its return on investment formula looks like this:
CoC Return = BTCF/Total Cash Invested x 100%
Best Used When: Cash on cash return, also known as the out of pocket method, more accurately represents the actual returns of a mortgage-financed income property compared to the previous ROI metrics. By using BTCF to include mortgage payments and debt service, and total cash invested to include down payments and more, CoC return paints a clearer picture of how a property is making money compared to its investment.
So far, we’ve seen different ROR formulas including rental income, cash purchases, and mortgage-financed properties. While all these factors lead to profitable investments, one more aspect is missing, one that every best real estate investment must have. That factor, of course, is equity.
Cost Method ROI = Equity/Total Cash Invested x 100%
Best Used When: The cost method is a return on investment formula that separates equity from other forms of profit. Use it to analyze the equity of an investment property in relation to its investment.
Total Return on Investment (TROI)
TROI = (BTCF + Net Sales Proceeds – Initial Cash Investment)/Initial Cash Investment
Best Used When: TROI is best used to analyze an investment property’s profit as rental income and equity/appreciation gains.