How to Calculate Your True Real Estate ROI
By Danny Tsang
November 21, 2007
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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Written by Danny Tsang · Filed Under Investing, Real Estate
