Three calculations every real estate investor must know
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 matters. If someone brags that they made $100,000 on a resale home investment, it’s much more impressive if their initial investment was $100,000 than it is if they invested $1,000,000.
It’s not just the initial sale that matters either. The actual initial cost is the sales price plus any costs of financing, transaction closing, or renovation prior to move in.
There are long-term costs as well. If someone bought stocks, the ownership of that stock didn’t cost them any money in taxes, maintenance, and upgrades. People tend to forget about those costs as they write it off mentally as consumption, but those are costs they would have avoided had they rented instead.
Further, the amount of time it took to obtain that profit is also critical. There are people who bought $1,000,000 homes in 2004 who can finally sell and make a $100,000 profit (forgetting about transaction costs, of course). It took them 12 years, and they endured 10 years of being underwater, but they made money, so it was a good investment, right?
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. Since the timing of these outflows and inflows are often separated by years, and since borrowed money is often employed, we need different financial measures of the rate of return.
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. This is the simplest calculation because since no debt is involved, the return on investment is the performance of the property.
I believe evaluating capitalization rates is important because extreme leverage — and most real estate transactions have extreme leverage (75% to 80% typically) — exaggerates the returns of nearly any investment and disguises 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.
The income from the property either is actual rental income or a measure of comparable rents, with my automated system, it’s the latter. 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, forming the basis of all return calculations.
I chose today’s featured property because it’s the kind of property I personally like to invest in. It’s a small 3/2 with a 2-car garage.
- The small size makes for smaller repairs when it’s necessary to replace carpets and repaint the house.
- A three bedroom and two bath house is the easiest to rent as it provides the most options for use.
- A working two-car garage is always preferable, so I tend to filter out those properties without it.
These are just my criteria, and there is a plethora of properties without these characteristics that provide even better cash returns — at least on paper. In properties lacking the standard criteria, vacancy is inevitably a bigger problem, particularly in an economic downturn. I leave those to other investors.
The capitalization rate on today’s featured property is 4.8% using the automated assumptions of the system.
In this particular instance, the automated rent is probably very close. A large number of similar properties rented for about $1,150, the automated value my algorithm came up with (click for larger version).
After pulling comps on over 1,500 properties while working in Las Vegas, I noticed certain methods of estimating comparable values worked better in some circumstances than others. I also noticed that if you averaged all these methods, it generally provided the most intuitively accurate method of establishing value. Although it probably would be frowned on by statisticians, I use this method because in my experience, it produces better results.
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 acquisition costs (down payment, renovation, closing costs) 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. Unfortunately, it is also nearly impossible to measure accurately. Why is that? Because computing the internal rate of return requires forecasting the future. You must estimate how much the property will appreciate, and you must estimate how much expenses will go up. Most people get this disastrously wrong. The capitalization rate and the cash-on-cash return do not require any forecasting (except perhaps “forecasting” current rents from comparables).
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.
Thursday night event
I will be speaking Thursday evening about real estate investing. Do you have questions you would like to ask? Come out Thursday evening. After the presentation, I will stay and answer questions about any aspect of real estate investing. I hope to see you there.