Real estate investing success is not achieved by a “secret” method. Successful real estate investing requires hard work, good research, and a systematic and stringent analysis of each and every investment opportunity.
Yes, a proficient real estate professional can help you find, research, and even analyze the profitability of specific investment opportunities. But that does not mean that you should not be prepared. It is imperative to your investment success for you to have some knowledge of the rates of return real estate investors commonly use during the analysis process before you make that all-important decision to purchase a rental property, regardless.
In this article, we will consider three of the most commonly used and popular returns and measures. By themselves, none of these is a deal maker or breaker. You would not make an investment decision based solely on the results of any of these numbers. But they are popular, you will hear them referred to, and it certainly will better prepare you to achieve your investment goal by becoming familiar with them.
1) Cash on Cash Return – Cash on cash return measures the return you can expect to receive in the first year of property ownership. In this case, the higher the cash-on-cash return is the greater the profitability of the investment.
Formula: Cash on Cash = Before Tax Cash Flow / Cash Equity (Initial Investment)
Test your understanding: Given the opportunity to invest $50,000 for a cash-on-cash return of 6.5% or an investment of $75,000 for a 10.2% return, which appears to be the better investment? Though it would require more cash outlay, the higher return, at least on the surface, seems to be the better investment. Why, because a first-year yield of 10.2% on your cash investment is better than a first-year yield of 6.5%.
2) Gross Rent Multiplier – Gross rent multiplier (GRM) measures the ratio between annual gross rental income and sale price. It is the least informative measure of an income-property primarily because it does not consider a property’s operating expenses, debt service or cash flow, and by itself is insufficient as a stand-alone number because it says nothing about a property’s profitability. Nonetheless, gross rent multiplier can be helpful for simple comparisons between rental properties. It is an easy calculation you can make in your head, and can be used when you simply want to get some idea how the price for one rental property compares to similar properties recently sold or currently for sale in the market. In this case, a higher GRM indicates a higher property value.
Formula: Gross Rent Multiplier = Purchase Price / Gross Rent
Test your understanding. If you are considering a duplex with a gross rent multiplier of 7.2 and know that two similar duplexes down the street sold recently at gross rent multipliers of 8.5 and 9.0, what does that suggest? That you could be getting a good deal, and might want to take a serious look at the property. Why, because the gross rent multiplier on the duplex you are considering indicates a higher ratio of gross rent to purchase price then the market seems to suggest.
3) Capitalization Rate – Capitalization rate (also called cap rate) essential indicates the percent of sale price attributable to net operating income (or NOI) and is important because it reveals what percent of the price is available to make the mortgage payment (the mortgage payment is deducted from the NOI). In this case, a higher cap rate indicates that more money would be available to pay the loan, and explains why lenders use it in their appraisals.
Formula: Capitalization Rate = Net Operating Income / Purchase Price or Value
Test your understanding. You know from your research that small office buildings in your area have typically been selling for a cap rate around 8.3%. The building you are looking at results in a cap rate of 6.8%, what does that say about the price? That unless there are some benefits to prove otherwise, the property might be over priced. Why, because the building in question indicates less net operating income as a percent of sale price compared to what the market suggests.
You get the idea. Pure luck is improbable to succeed at real estate investing. So seek out a real estate agent who can help you with the research, and a good real estate investment software solution to run the numbers for you. Because the more prepared you are for real estate investing, the better your chances are to make money at it.
Here’s to your real estate investing success.