Topic of this week’s blog may be a constantly rehashed one but needs to be revisited periodically, in order to allow decisions based on facts rather than emotions and hunches. Let’s discuss few accounting and financing terms to ensure that you are staying on course for the right reasons. Few of the investors take time to calculate Return on Investment (ROI) on a regular basis. ROI can be calculated with few different numbers and you may incorporate one or all or a combination of these numbers depending on your investment goals.
We will start with the most basic and easiest to calculate.
1) Cash flow – This is the amount of cash left at the end of the month after you have subtracted all the expenses from the rental income for the property. Expenses would include mortgage, property tax, insurance, any repairs on a monthly basis
Here is a hypothetical example
Rental Income = $1150 – Expenses = $1022 = Cash flow $128
2) Net Operating Income (NOI) – This is same as cash flow but do not take the mortgage in to account for expenses. Very useful for comparing multiple properties as each property may have different loan conditions.
For our example, removing mortgage expense of $604 would yield NOI of $1150 – $418 = $732
3) Cash on cash return – This is the yearly cash you get divided by the initial investment. So from example one, you get is $1536 and your initial cash investment was $20,000, cash on cash would be $1536/$20,000 = 7.68%. You may have a set number that you expect your property to generate or you may want to compare this against other types of investment such as stocks, bonds and decide which one would make more sense in a given market.
4) Capitalization rate – This is the ratio of yearly NOI divided by the purchase price. In our example this would be $732 X 12 / $117,000 =7.5%. Again, you may set a bench mark for yourself or compare against different options available.
5) Appreciation –Historically real estate has appreciated, and you can see the trends for a particular market for the near future of 3-5 years but remember that it is an estimate based on past conditions. How much to focus on appreciation depends on your investment goal. You can look at the indicators such as a job growth, population growth, and the economic development to estimate a rate of appreciation.
As you look at your goals and compare against the real numbers, you may come to conclusion of changing your course for a particular property or it may affirm your intuition that you have made a correct decision and allow you to have peace of mind. Either way, few minutes spent twice a year is well worth the investment.