(This advanced blog summarizes real estate investing tips and insights Lofty AI has acquired from working with thousands of investors and institutional funds.)
This post teaches you the 4 most common rental property rate of return calculations.
You want to use these calculations to determine which properties are sound investments, and which properties are not.
The 4 methods to calculate the ROI of a rental property are:
Each method is useful in certain situations. This can make it challenging to determine which real estate real estate investment calculations you should be using.
This post teaches you each method in detail.
Cash on cash return measures your received pre-tax cash flow relative to the amount of money you invested to acquire the property.
Cash on cash return is the easiest and most popular method to calculate the ROI of a rental property.
Otherwise known as the equity dividend rate, the cash on cash return real estate ROI calculation is the following:
Your first step, when analyzing a potential investment property, should be to calculate the cash on cash return.
Here are a few reasons why:
Say you're looking to buy a duplex for $300,000.
Below is the step-by-step process to calculate your cash on cash return:
In this example, your cash on cash return is 11.4% ($8,000 / $70,000).
This means the property’s annual profit for that year will be 11.4% of the cash initially invested.
While cash on cash return is a very simple real estate ROI calculation to compare properties, it does have its downsides:
There is a consensus amongst investors that a cash on cash return between 8 to 12 percent indicates a worthwhile investment. Others argue that in some markets, even 5 to 7 percent is acceptable.
Say you're investing in a property in a neighborhood that's appreciating 20% per year, but you only have a cash on cash return of 3%.
In that scenario, you'd make much higher returns than if your cash on cash return was 10%, but your property was only appreciating 5% per year.
It depends on if you're able to wait until you sell the property to collect the additional income from appreciation. Or, if you're looking for more consistent cash flow throughout the lifecycle of the investment.
When you hear real estate investors use the phrase “mailbox money”, they’re referring to cash flow.
Cash flow is income generated when your rental returns exceed your monthly expenses.
It's one of the most popular ROI calculations.
For buy-and-hold investors, cash flow is king.
How much cash flow, if any, can John plan to receive each month?
Add all these expenses up and it comes to $1,140 per month.
$1,350 (rent return) – $1,140 (expenses) = $210/month
This means that John will be receiving $210/month in profit from this rental property.
That's what we call positive cash flow or mailbox money. 🤑
The 50% rule is a back-of-the-envelope formula. Similarly to cash on cash return, investors use it to analyze a potential deal quickly.
The rule says that you should estimate your operating expenses to be 50% of your rental income.
If a rental property makes $50,000 per year in gross rental income, you should assume that half, or $25,000, will go towards expenses,
The 50% rule is an estimate created by experienced real estate investors. It allows you to quickly compare potential investments to identify which properties will cash flow and which ones will not.
Keep in mind that this rule is based on assumptions that have yet to be verified.
We'll be discussing the 1% rule next.
The 1% rule is a back-of-the-envelope ROI calculation.
According to the 1% rule:
For a $100,000 property to be considered a good investment, it must rent for $1,000/month or more.
The 1% rule is helpful for a few reasons:
If the rent is only $500/month, the $100,000 price will not meet the rule.
Or if you had to pay $150,000 for a property that rents for $1,000, it would not meet the rule either.
There's also the 2% rule.
What is cap rate in real estate? Cap rate, or capitalization rate, is an ROI calculation used to compare similar real estate investments.
The cap rate is the rate of return you can expect on your investment based on how much income you believe the property will generate for you.
The higher the cap rate, the better.
Cap rate formula:
Net operating income (NOI) is the annual income generated by the property after deducting all operational expenses.
This includes both property management fees and taxes.
You can run a calculation for the cap rate by using the net operating incomes and recent sales prices of comparable properties.
The cap rate is determined and then applied to the property you're considering purchasing. This helps to determine its current market value based on income.
Below is an example of a calculation for cap rate for three different properties:
There are many factors that influence what a good cap rate is.
The current rental income of a property determines its cap rate.
Ideally you want the rent to be as high as possible when you first buy the property, which will cause the NOI to increase giving you a higher cap rate. Remember, the NOI is calculated by subtracting operating expenses from the total revenues of a property.
The issue with most investors is that they'll only look at the rental income at its present value.
What you want to do instead is determine the cap rate once you add value to the property. This could mean replacing roofs, mowing the lawn, or any other work which helps to increase rents. When rents increase, so does the cap rate.
Unless you're buying class A properties, you will most likely be doing work on your properties. Once the value-add work is complete, the goal is to be able to both charge higher rents and reduce your vacancy rate.
To predict what rent and vacancy rates will be in the future, investors will use a rent pro forma.
A rent pro forma is a detailed break down of the income and expenses of a rental property once it is fully stabilized and operating at peak efficiency.
Peak efficiency means that it has the market rents, income, vacancy rates, and operating costs compared to other properties with a similar class and age in that market.
Like most ROI calculations, determining what is "good" has a lot to do with your risk tolerance.
To further explain, let’s take a look at two investments, one that’s a 5% cap and one that’s a 7% cap rate.
The property with a 5% cap rate may be a good fit for an investor looking for more of a passive and stable investment. It might be in a better location currently, but has a lower chance of rapid future appreciation.
The property with the 7% cap rate is a better fit for an investor that’s willing to take more of risk. But with risk, often comes reward. Though less stable, this property will have higher upside potential for appreciation.
Some real estate investors consider appreciation a "nice to have" compared to cash flow. This is due to the fact that it's simple to project cash flow. But it's extremely difficult to predict appreciation.
Throughout history, predicting appreciation has always been a guessing game. Luckily, there are tools today which make predicting appreciation accurately, possible. For example, Lofty AI uses artificial intelligence and real-time social data to accurately predict appreciation down at the block level.
Let's say you buy a property with 5% cap rate and another property with a 10% cap rate. Right off the bat, the 10% cap rate property is doing much better. It's generating more revenue and is in a more stable neighborhood. But, what if the 5% cap rate property was in Williamsburg, NY 10 years ago? Or The Arts District in Los Angeles 7 years ago?
Property prices literally doubled in value within a 2 year period in both of those markets. The 5% difference cap rate is negligible when you take into account returns you'd get by owning a property in one of those neighborhoods.
The cap rate is an important ROI calculation for many reasons:
Like cash on cash return, there is no exact answer to the question of "What is a good cap rate?"
Again, it really depends on your preferences and risk tolerance.
To further explain, let’s take a look at two investments, one that’s a 5% cap and one that’s a 7% cap.
The 5% cap property might be a good fit for an investor looking for a more stable and passive investment. It may be in a better location with a better chance of appreciation.
The 7% cap property may be a good fit for an investor that’s willing to take more of a gamble and risk. It might have a better upside as well but is less stable.
Defining a good cap rate also depends on the future potential of the investment property. If you're able to increase rents and maintain a similar occupancy rate, you'll naturally drive up the cap rate over time.
A property’s internal rate of return (IRR) is an estimate of the value it generates during the time frame in which you own it.
Effectively, the IRR for real estate is the percentage of interest you earn on each dollar you have invested in a property over the entire holding period.
For example, say you purchase a triplex to rent out and you plan to hold the property for 5 years. You’d earn interest on the rental income you receive during the first year for the remaining four years. Income received in the second year would earn interest for the next 3 years, with each new year generating more interest.
All the interest earned over the full 5-year period would represent the IRR.
Formula to calculate IRR:
Where:
N: Total number of years
Cn: Cash flow in the current period
n: Current period
r: Internal rate of return
Or, similarly:
(Cash Flow Year 1/(1+IRR)^1 + Cash Flow Year 2/(1+IRR)2 + Cash Flow Year 3/(1+IRR)^3) - Initial Investment=0
Say you purchase a property for $123,400, the year 0 cash flow, and your cash flow in year 1,2, and 3 are the following:
then the IRR r is given by:
In this case, the IRR is 5.96% (in the calculation, that is, r = .0596).
Doing the internal rate of return calculation by hand can get long and messy. We recommend that you use Excel or an internal rate of return calculator that you can find online such as this one.
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