While no real estate investment is totally simple and without risk guaranteed, there is a simple concept that, if applied, will give you a clue as to whether a particular real estate investment is too risky or even worse, a money-loser.
Residential Real Estate
This article is going to limit itself to a discussion of residential rental property investing. This refers to any single or multi-unit properties, such as houses or apartment buildings, where the owner is the landlord and the return on their investment comes from tenant’s rents.
The first thing to know is that, generally speaking, two similar properties in dissimilar areas are not necessarily equally good investments. What this means is that a single-family rental house in the inner city or close to a university campus is not going to provide the same kind of returns as a single-family rental house in a middle-class suburb.
We will take a closer look at the reasons why further down in this article.
The second thing to know is that, as with any investment, you must “listen to the numbers,” not to your emotions. That quiet, boring duplex with the ancient linoleum and peeling paint may not excite you as much as a four-bedroom house on a cliff overlooking the ocean, but it might excite your portfolio quite a bit, so go with numbers, not feelings.
How to “listen to the numbers” will be explained as well, a bit further down.
Two Ways Real Estate Generates Money
Again, we are talking about rental property. The two ways you make returns on your rental property investment are rental income and long-term appreciation.
If you’ve paid much attention to the real estate market in general, you know that the prices go up. For owners, that’s called “appreciation.” It means, the value of something increases. In many scenarios, a piece of property will appreciate over time but you can’t rely on it. Appreciation is not the kind of investment return we’re going to concentrate on.
Now, understand that merely owning a rental property and collecting rent from tenants every month doesn’t equal positive cash flow—more money coming in than going out. It’s entirely possible to lose money through negative cash flow—more or the same amount of money going out than coming in—so, you’ve got to consider the numbers.
The rental income you collect in a year needs to be an acceptable percentage of the money you invested to purchase the property. That percentage has to be wide enough to absorb expenses and other costs and still give you a good return.
This percentage is referred to as the “cash-on-cash return” and is the most important initial measurement of a good rental property investment.
How to Figure Cash-on-Cash Return
The reason for doing a cash-on-cash return calculation is to see how high the percentage of return you can get from your investment.
It’s a very simple thing to do and is considered by many experts as the most importantmeasurement of a potential property investment, yet you would be surprised how many people make bad real estate investment choices by neglecting it.
You do a cash-on-cash return calculation using the amount of cash you invest (not including any borrowed amounts) and the total annual rental amount the property generates.
For example, a house rents for $2,000 a month. The property might have $500 in operating expenses, which leaves a net income of $1,500. Let’s say there’s a mortgage on the house with a $1,000 monthly payment. That’s a monthly cash flow (we don’t yet know if it’s negative or positive) of $500 a month, or $6,000 annually.
Let’s say that your equity (the amount of cash you personally put into the deal) is $50,000. You divide the annual rental cash flow by your equity:
$6,000
———– = 0.12 x 100 = 12%
$50,000
You would be looking at approximately 12% return in the first year. That may not be typical but even if it were only 6%, it’s pretty good, when compared to other kinds of investments. As of this writing, stocks offer returns of about 7.5%, bonds 4.5%, and CDs 1.5%. Real estate is usually a higher-risk investment and thus, should have a decent rate of return.
A word about expenses: Earlier in this article, it was mentioned that, “two similar properties in dissimilar areas are not necessarily equally good investments.” This is a matter of expenses. While the surrounding community would factor in the state of a particular property, you have to consider possible expenses that you might have for example, with student housing or properties in lower-end parts of town.
If you look around a neighborhood and see a lot of damage, neglect, and disrepair, it’s a possibility that owning a property in that area means handling similar problems. This will eat into your cash flow and reduce the return on your investment.
Positive real estate investments should be in areas that display an outward sense of pride: clean, quiet, and orderly.
If you find a property like that and your cash-on-cash return looks good, you may just have a winning investment. What’s even better is that rental income can increase, which means greater cash flow. Expenses can also increase but your mortgage payment will stay the same. Overall, your percentage of return will go up a bit each year.
Final Words
There are other factors that may need to be analyzed before going forward with an investment purchase—things like income taxes and amount borrowed—but a simple cash-on-cash return calculation is an easy and fast way to confirm if a deal is worth pursuing.
