Friday, February 22, 2013

Calculating the ROR on Real Estate

Cash on Cash Return On Investment Method

The cash on cash return on investment is the Annual Before Tax Cash Flow divided by your initial cash investment. The formula looks like this:

Cash on Cash Return on Investment  =  Annual Cash Flow / Initial Cash Investment

Annual Before Tax Cash Flow: calculated by subtracting your annual mortgage payment from your net operating income (NOI). The net operating income is simply the total income from the property minus the total expenses.

Example: $150,000 purchase price for an income property requiring a 20% down payment of $30,000. Annual Before Tax Cash Flow is $3,000 per year.

Cash on Cash ROI  =  $3,000 / $30,000  =  10%

The cash on cash ROI is a good measure of a property’s first year financial performance. However, it does not include the additional benefits achieved through real estate such as the amortization of the mortgage and any future appreciation. The total return on investment addresses that.

Total Return on Investment Method

The total return on investment provides a better and more complete measure of a property’s financial performance. That is because it factors in amortization and appreciation gained over time.
Total ROI  =  (Annual Before Tax Cash Flow + Net Sales Proceeds – Initial Cash Investment) / Initial Cash Investment

In order to calculate the total return on investment, one must project the net sales proceeds from the future sale of the property.

Let’s take our example above and assume we have 30 year mortgage with a 7% interest rate and we plan to sell it in five years with an average annual appreciation rate of 4% per year. After five years our $150,000 property would be worth $182,498, and our mortgage balance would be $111,665. Let’s also assume that our selling expenses total 5% of the sales price, or $9,125.

Using the figures above, our net sales proceeds from the sale of the property in year five would be $61,708 ($182,498 – $111,665 – $9,125). Additionally, our before tax cash flow after five years would total $15,000 assuming no annual increase in rents or cash flow. Formula looks like this:

Total Return on Investment  =  ($15,000 + $61,708 – $30,000) / $30,000  =  156%

To say it another way… You earned a profit a 56% on your initial investment after your initial investment was returned. But I would recommend looking at your profit as an annual percentage so you can compare it to other investments like stocks and mutual funds. The annual rate of return on this 5 year investment was 9.26% per year. So another investment would have to earn you at least 9.26% per year over the same 5 year period assuming the same risk level.

Note that some investors calculate their total return on investment using their after-tax cash flow instead of the before tax cash flow. However, it does not provide a good measure to compare one investment to another since tax liabilities will vary between individual investors.

The total return on investment can be a little shortsighted when used in isolation. This is because total return on investment does not measure of the property’s financial performance as it relates to its equity. For this we must calculate the property’s return on equity (ROE) which I will save for another day.

This is just some of the basics, and can be a little overwhelming especially for beginner investors. That is precisely why you need a CFP, knowledgeable Real Estate Agent, and Tax Expert on your team.


Ned Polian said...
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Ned Polian said...

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