How to Calculate Your True Real Estate ROI
21 November 2007
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Its not that hard to calculate cash flow and returns of an investment property, yet many people get it wrong. My dad, along with many old school people who stumbled into the world of real estate investing, only understands the buy price and the sell price. He thinks that if he bought a house for $100K and sold it for $200k ten years later, he made a killing. To most people, he doubled his money and it doesn’t sound too bad. However, if he factors in holding costs, vacancy, repairs, closing costs and selling expenses, he probably could have put the money in a hands off passive mutual fund and did a lot better. This is why it’s important for the novice or casual real estate investor to really examine the numbers so you can estimate your return on investment and compare it with other investment vehicles such as the index funds and ETFs.
Calculate Cash on cash return
You need to understand your cash on cash annual return. This essentially takes into account all of your expenses and gross income and gives you a reliable annual return on your money. If this is a multi-unit building, a commercial building or a single family residential income property, these figures are usually obtained through the seller. However, a lot of it relies on your own research and knowledge of a particular area. If it’s a house you’ll have to find out all these numbers yourself and perhaps your agent can help too. The following is a real life example of a 4 unit multi family property I evaluated that was listed at $275K. Here is a snapshot of an excel sheet I created to evaluate the property:
The cash on cash return is 5% a year at a 25% down payment, which isn’t great with this particular property but its decent since the property in a good area. When doing your own calculations, remember to use the price that you assume you will pay for the property, not the asking price. Also, for my personal calculations I do leave out closing costs on the purchase because I usually ask the seller to pay. I also left it out on the future selling side because I would work out a deal with my agent so that they would charge me less commission on in exchange for long term business. So I build the closing costs into my 5% selling commission since I will probably be paying 4% instead. Your cash on cash return changes drastically with different down payment amounts, costs and rents. So do your homework and develop an accurate cash on cash calculation.
Calculate Your Internal Rate of Return
Your IRR is your total return on the investment, including the appreciation, rental growth and everything else during your holding period. I usually assume a modest rental income growth rate and appreciation rate and I hold for the long haul. Here is the second part of my excel sheet that calculates IRR.
When you factor in appreciation and rental growth, you get your true return, an IRR of 15%. That’s not bad, but I don’t like to depend on appreciation, which may not be there, so I didn’t move on this particular property. When you are equipped with this number, you can accurately compare it to other investments be it another property, an index fund or even a business venture and make an solid and decisive investment.
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Thank you thank you thank you!
People don’t seem to register that the interest on a mortgage loan = a cost of owning property that comes out of your pocket, and that over 30 years it effectively doubles the amount you pay just for the privilege of throwing some more money into the place. This is why mortgage debt on your own home, while it’s probably unavoidable for most of us, is not “acceptable” debt.
You can & should track the day-to-day cost of owning your house (& investment property, if you have it) in Quicken or Excel. Set up categories that describe, with some degree of reality, how your costs are adding up. Upgrades (such as painting, new carpets, hard-wired lighting, a new toilet) come under the heading of “capital investments”–include even the cost of materials for DIY projects. Maintenance, property tax, insurance, and payments toward principal & interest should be tracked separately. You’d have to pay your utilities if you rented, but every other item that you would not have to cover if you were renting should be figured as a cost of the property.
Run a report toting up these figures once a year, and you’ll see that if you buy your palace for $200,000 and after a while sell it for $300,000, your profit is a lot less than it looks–especially if you paid 6% off the top to a Realtor.
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