If you decide to buy an investment property with the target to achieve a good annual rental return, how do you decide what is a “good return” and how do you calculate it?
There are many metrics and indicators to quantify the profitability of a property investment. Among others, you will come across measures like return of investment, return on equity, internal rate of return (IRR), or terms like gross/net profits, leveraged / unleveraged returns and pre-tax / post-tax income. All of these indicators are looking at the financial attractiveness of a real estate investment. However, while these measures are helpful for the seasoned real estate investor evaluating an investment from different angles (e.g., the timing of cash-flows or different tax positions), they can be quite confusing for a first-time property investor.
In this article, we highlight three main metrics a real estate investor should know and focus on when looking to buy his/her first property:
- the Return on Investment
- the Capitalization Rate and
- the Cash-on-Cash Return
1. The Return on Investment (ROI)
The ROI measures the return (gross income) of an investment in relation to the investment costs (= price plus side-costs):
ROI = Return ⁄ Cost of Investment × 100%
The calculation of the ROI should always be the first step when evaluating and comparing potential property investment. The data required to calculate the ROI is often readily available and gives a first idea of the profitability of a project. For example, if the purchase price for an apartment is USD 250,000 (including side-costs like legal fees, agent fees, stamp duties, etc.) and the annual return on the investment (i.e., rental income) amounts to USD 25,000, then the annual ROI of this property is 10% (= 25,000/250,000 * 100%).
While the ROI is a very flexible measure, it also has shortcomings. It does not consider the investor’s regular investment expenses nor any financing options. For instance, if in the above example the annual return (= rental income) does not change, the ROI will always be 10% irrespective of an investor paying annual maintenance or interests on a mortgage loan. To consider such factors we must use the other two metrics Cap Rate and Cash-on-Cash return.
2. Capitalization Rate (Cap Rate)
Similar to the ROI, the Cap Rate calculates the return of an investment in relation to the overall cost to purchase a property. However, instead of taking the gross income, it is based on the net operating income. It also considers the regular property expenses (like maintenance, insurance fees, etc.) which are deducted from the gross income to derive to the net operating income (NOI):
Cap Rate = Net Operating Income ⁄ Cost of Investment × 100%
Let’s take the earlier example of a USD 250,000 apartment purchase. The net operating income equals USD 20,000 if we assume annual property expenses for maintenance and insurance of USD 5,000 (= 25,000 – 5,000). Accordingly, the Cap Rate of the property equals 8% (= 20,000/250,000 * 100%).
Compared to the ROI, the Cap Rate is a more accurate reflection of the profitability of an investment as it also considers regular costs incurred by the investment. However, since at the outset of an investment, these expenses are often not known or might vary greatly over periods, we have to use the ROI instead. Therefore, the computation of the Cap Rate is usually the second step after the initial investment screening. Once we shortlisted an investment, we should identify and consider the related expenses to calculate the Cap Rate to get a more accurate idea of the profitability of the shortlisted investment.
3. Cash-on-Cash Return (CoC)
The cash-on-cash return is an even better profitability metric than the Cap Rate as it considers not only the actual net return of an investment property but also the actual money required by an investor to purchase the property.
CoC = Net Operating Income ⁄ Total Cash Invested × 100%
Most property investors will not have the funds to buy the property only with cash. Instead, they will use financing via mortgage loans to buy a property. The actual funds required by an investor can greatly differ from the overall investment required to purchase the property.
Using the earlier example of the USD 250,000 apartment purchase, an investor who can achieve 80% financing, only needs to invest USD 50,000 in cash to buy the apartment. Let’s assume he receives USD 25,000 in annual rental income, has to pay USD 5,000 in annual expenses for maintenance/ insurance and has to pay USD 10,000 in annual interest fees for the mortgage loan. The balance between the rent received and all related investment expenses result in a net operating income of USD 10,000 (= 25,000 – 5,000 – 10,000). Accordingly, the CoC return of the apartment purchase is 20% (= 10,000/ 50,000 * 100%).
All three measures, ROI, Cap Rate, and CoC, are useful and should be applied when evaluating a property investment for rental purposes. The ROI is easiest to use as data is most readily available. The Cap Rate is a better reflection of the net return of an investment but it requires additional information like investment expenses. The CoC is the most accurate profitability measure of the three but often harder to calculate. It requires data on expenses and financing costs that are sometimes not as readily available.
We should mention that the application of the three measures is not exhaustive for a comprehensive investment analysis. They do not cover aspects like the change in valuation of the purchased property over time, the timing of cash flows, or currency risks. To make an informed investment decision each investor must account for his/her unique investment situation.