How to calculate real estate investment returns
The three main measures of financial performance for rental real estate are capitalization rate, cash-on-cash return, and internal rate of return.
When people buy a personal residence, they often solace themselves that the high prices is warranted because the property is a good investment. Novices generally assume that anything they sell for more than they paid is a good investment without any understanding of what a good investment really is.
It’s not enough to merely make a profit, the amount of profit relative to the amount of money spent is also important. Further, the amount of time it took to obtain that profit is also critical. To really measure whether or not an investment is a good one, the investor needs to measure a rate of return on the amount of money invested.
The return on real estate is measured in three ways: capitalization rate, cash-on-cash return, and internal rate of return. Each of those is described in detail below.
Calculating capitalization rates
The basic calculation I perform is the capitalization rate, the net operating income divided by price. The capitalization rate is the return an all-cash investor would obtain from the property.
The income from the property either in rental income or a measure of comparable rents the owner would have paid if they were a renter instead of an owner. The expenses include those costs incurred by owners that are not incurred by renters: property taxes, Mello Roos, insurance, and HOA fees. The net operating income (NOI) is the rental income minus all the expenses, and it forms the basis of all return calculations.
It is always wise to examine the unleveraged returns of any investment as extreme leverage can exaggerate the returns of nearly any investment and disguise the underlying risk. For example, most people believe real estate provides a great return because the amount of equity gained from a small down payment can be very large. This looks great when house prices rise, but the perils become obvious when house prices fall — and they can and do fall.
To obtain the capitalization rate for an entire zip code, I obtain four values from the MLS:
- Average rents over last 30 days
- Average square feet of rentals
- Median sales price
- Average square feet of resales
The square footage is necessary to normalize the numbers. Although not perfect, normalization by square footage is far superior than simply taking the raw rental number and dividing it by the median home price.
From these four pieces of data, I calculate the capitalization rate and create my monthly reports. Today’s featured property is in Victorville, a community with an area-wide capitalization rate of 6.2%. Any time the capitalization rate is higher than the prevailing mortgage rate, the market is ripe with good investment opportunities.
The capitalization rate on today’s featured property is 6% using the automated assumptions of the system.
In this particular instance, the automated rent is probably $100 to $150 too high, but since this is a fully renovated flip, the renovation costs would be zero. (Click for a larger version)
Cash-on-Cash return calculations
The cash-on-cash return is more important than capitalization rates for the average investor who uses debt to acquire real estate. The cash-on-cash return compares the down payment to the cashflow remaining after interest is paid (includes positive cashflow plus amortization).
The calculation for cash-on-cash uses the capitalization rate calculated above and magnifies it — both up or down — based on the financing terms. The lower the down payment, the greater the returns are magnified. This is why speculators were keen to use 100% financing when it was made readily available during the bubble. Returns were infinite, and the risk of loss was passed on to the lender.
The fulcrum point of leverage is the interest rate. The interest rate must be lower than the capitalization rate for debt to have a positive effect. This was one of the key mistakes investors made during the bubble. People were buying properties with 4% capitalization rates using 6.5% debt. That’s crazy. No sane investor would apply debt that is more expensive than the capitalization rate — insane speculators do this all the time, but the moment prices go down, and the property cannot be sold for a profit, the negative cashflow of inappropriately leveraged real estate eats people up.
Since the capitalization rate is higher than the expected mortgage rate, this property has a magnified cash-on-cash return.
Internal Rate of Return
Current cashflows are not the only ways investors profit from real estate. The housing bubble was characterized by an overly exuberant opinion of future appreciation, and I have consistently decried considering appreciation as a reason to buy real estate in direct response to the foolishness of bubble-buyer attitudes. However, real estate can and does appreciate, and resale at a higher price in the future does have value. The best way to calculate this value is through a discounted cashflow analysis. When examining the rate of return of real estate, the internal rate of return is the best method available.
I won’t attempt to walk anyone through the math of the internal rate of return calculation. Like everyone else in finance, I use a spreadsheet to calculate it for me. The concept of internal rate of return is not nearly as difficult to understand as the math used to calculate it.
Imagine you are buying a house for $123,000 you believe will be worth $215,000 10 years from now. What is the current value of the $93,000 profit you will obtain in 10 years? It depends on the interest rate. That calculation is what finance people call net present value.
Now Imagine you could put $123,000 in a bank account earning a high interest rate (I know you can’t today, but just imagine). What interest rate would be required to have your $123,000 grow into $215,000 at the end of 10 years? That interest rate would be like the internal rate of return on the property that increased in value by the same amount over the same period.
Internal rate of return considers more than just the lump sum at the end. Internal rate of return compares the amount and timing of all the cash inflows and compares it to the initial investment amount to compute an overall rate of return on the investment. Internal rate of return is the most accurate measure of the financial performance of real estate.
So which is best?
Since most investors are financed investors, the proper evaluation of returns is cash-on-cash because it provides the rate of return on the actual cash outlays put forth by the investor. The capitalization rate is the cash-on-cash return of an all-cash investor. The capitalization rate is a useful tool for evaluating markets and screening large numbers of properties, but investors should refine their estimates of renovation costs, maintenance costs, and rental income when making their final selection. The internal rate of return is the most accurate, and it is the one favored by sophisticated investors analyzing complex deals, but residential rental properties analysis need not be that complex, and many people who start projecting the future based on growth rates and such end up deluding themselves into believing the investment will perform better than it really will — that’s why I don’t bother with internal rate of return when evaluating rental properties.