One of the questions I am asked often is how I know if a property is a good investment. To me, the answer to this question translates into knowing exactly how to calculate ROI on investment property. The reality that folks are willing to put money under my management via syndication of real estate is in part a function of me knowing precisely how to calculate ROI – all of the ways to do so.
It is important to understand that what makes a piece of investment-grade real estate actually a good investment opportunity is only partially a function of the numbers – there are a lot of less quantifiable and less obvious aspects of any given opportunity that need to be taken into consideration. I will go even further by saying that it happens quite often that all of the numbers look stellar, and yet the opportunity is actually very flawed…
I cover all of the perspectives that apply to this conversation as part of the Cash Flow Freedom University, so I will not attempt to do anything more here than address the numbers. Indeed, the scope of this article is to simply address the main numerical measurements that we use in our analysis process, and I will try to do so in fewer than 3,000 words- although this will be a challenge.
I will begin with the most general metrics – a birds-eye view of the property from 1,000 feet in the air, so to speak. And as the article progresses the metrics will become more specific. And now, without further adieu on to how to calculate ROI on investment property…
Yield should most easily be thought of as the gross revenue, which in the world of real estate is simply the sum of all rental and other income attributable to a building. For example, if each unit in a 4-plex rents for $500 per month, then the monthly yield is $2,000, while the annual yield is $24,000. If, however, there happens to be a coin-operated laundry in the building which brings-in an additional $100/month, then the monthly Yield is $2,100.
Yield represented as a percentage is calculated with the following formula:
Yield = Annual Gross Revenue / Price (Value)
Thus, if you pay $130,000 for a 4-plex which generates an Annual Gross Income (Annual Yield) of $24,000, then it can be said that your investment yields 18.5%:
Yield = $24,000 / $130,000 = 18.5%
Yield as a measurement of the health of a real estate investment is rather limited by the fact that it focuses strictly on the income side of the operations structure and does not take into account the expense structure of the building. As a result, it is possible to have two buildings with an identical Yield produce substantially different NOI (Net Operating Income – discussed in next section) based on the reality that one costs a lot more to operate and maintain than does the other.
As such, the only useful application of this metric is with respect to determining whether the income streams being advertised / represented by the seller appear to be in-line with other buildings of similar nature and in similar location. Naturally, knowledge of the marketplace is requisite to make this determination…
Gross Rent Multiplier is a coefficient that represents the general dynamic in a marketplace relative to how much investors are willing to spend for income as is represented by Gross Rent. While we do pay attention to the GRM when analyzing larger apartment buildings, it is very under-weighted in this environment for reasons that will become apparent to you as you continue to read. However, the GRM is indeed the prevalent metric when apprising buildings with 4 units or fewer; in other words, when appraising any structure the can be financed with a residential mortgage needs to be evaluated via GRM.
The GRM provides us with a very vague look of the financial health of the building for the same reason as does the Yield – neither takes into account the expense structure of the asset, which makes it highly imprecise. But, since people do use it, you should know it, and here’s how the GRM works:
If someone pays $120,000 for a building which brings in $2,000/month of Gross Rent, then the multiple which relates the Gross Income to the Purchase Price is 60:
GRM = Purchase Price (Value) / Gross Income = $120,000 / $2,000 = 60
This number “60” is the Gross Rent Multiplier in this case. If, however, the Gross Income in this building were $2,200, then having paid $120,000 for the building the buyer will have realized a GRM of 54.5:
GRM = Purchase Price (Value) / Gross Income = $120,000 / $2,200 = 54.5
Now – let’s say that you analyze 10 buildings in a given marketplace of like character and realize that all of them sold in the range of 65 to 75 GRM. Armed with this information you can determine a value of your building relative to the GRM Method by multiplying the Gross Income (Yield) of your building by the appropriate multiplier.
What is the appropriate multiplier; after all 65 – 75 is a big variance? Well, it would be easy enough to add all 10 of your comps together and divide by 10 to arrive at an average. The problem with doing that, however, is that the variances in the GRM multipliers likely indicate differences in amenities, age, and condition of the comps, and by simply using an average you would not arrive at a multiplier that is sensitive enough. It is better to arrive at “weighted” GRM coefficient that would most closely fit the type and condition of the building that you are valuing. This, however, is a job, and I suggest that it’s best to ask an appraiser.
Having said all this, however, understand that the GRM Method is not very accurate in the first place since it does not account for expenses. As such perhaps an average is OK to use after all. Thus, if your building, or the building you are trying to valuate brings in $2,000/month of Gross Income, then the GRM method would value it at $120,000 presuming multiplier of 60, and $130,000 presuming a multiplier of 65, and so on…
To do better than this, we have to account for the expense structure of the asset
Net Operating Income (NOI) is the measurement of the income-potential of a piece of income-producing real estate which accounts for the expense structure of the asset. The NOI provides a very detailed look at the health of the investment, and it is used as the basis for estimating the value of the investment through the Capitalization Rate Analysis, which will be addressed further in this article. The formula for NOI is as follows:
NOI = Gross Income (Yield) – Operating Costs (Not including cost of money)
With respect to this formula, it important to understand that the Cost of Money (Debt Service), which is essentially the sum of all mortgage payments, is not figured into the NOI calculation as one of the expenses. The reason for this is that the mortgage payment depends on the amount and the terms of the Leverage, or lack thereof. For instance, if someone were to pay all cash for the building, then they obviously would not have any payments for the mortgage because they would not have a mortgage. On then other hand, someone like me might finance the entire purchase and back into very substantial debt service. Regardless of how we do it, all of us need to be able to conduct an apples to apples analysis of the income-potential of the building, and the most reasonable way to do so is by excluding the cost of money. This is why the NOI is used to underpin the valuation process in commercial real estate.
Thus, if the 4-plex you are considering shows $2,000/month of Gross Income, and all of the expenses such as Property Taxes & Special Assessments, Owner-paid Utilities, Upkeep, Lawn Care & Snow removal, Vacancy Factor, Management Costs, Fire Insurance, etc. add up to $800/month, then the NOI of this building is $1,200/month:
NOI = Gross Income – Operating Costs = $2,000 – $800 = $1,200/month
This number $1,200 gives us a much more honest perspective on the income-potential of the building than if we simply consider the Gross Income.
Furthermore, if we want to estimate a value of this building we can do so with much more precision by using the NOI as the basis rather than the GRM. The process of doing so is called Capitalization Rate Analysis…
First of all, capitalization rate is simply understood as the rate of return that a reasonably aggressive investor would be willing to receive on his/her investments in real estate. The rationale is rather simple in that every investor has to ultimately make the call on what rate of return is good enough for them to “pull the trigger”- at what point does it become “worth it” to put your money at risk?
For instance, if you are comfortable deploying capital so long as you can generate at least a 10% return, then you should be willing to pay $144,000 for the 4-plex we’ve been discussing. Why – because $1,200 of monthly NOI constitutes an annual return of 10% at the price of $144,000
$1,200 x 12 = $14,400 which is 10% of $144,000
Thus, the formula for capitalization rate is:
CAP Rate = NOI / Price (Value)
Now – to place a value on income-producing property relative to the CAP Rate and its income we simply invert the capitalization formula:
Value = NOI / CAP Rate
Thus, once you’ve researched the income and expenses of a building and have arrived at an NOI, you can estimate the value of the income stream represented by this building. In the case of our 4-plex with annual NOI of $14,400, and presuming a CAP Rate of 10%, the market valuation is $144,000:
Value = NOI / CAP Rate = $14,400 / 10% = $144,00
Interestingly, should the going CAP Rate in your marketplace be 7 CAP and not 10, then the valuation would look very different
Value = NOI / CAP Rate = $14,400 / 7% = $205,714
Indeed, a 3 point swing in the capitalization rate caused the valuation to jump from $144,000 to almost $206,000. Thus, in order to conduct an honest valuation of real estate you must have knowledge of precise CAP Rate which is prevalent in a given marketplace.
To figure out the going CAP Rate in a given marketplace you would need to do similar research as what we discussed relative to the GRM. However, in lieu of needing to find out prices of the comps and their corresponding gross rents, in this case you will need to know the NOI of the comps. This, as you can imagine, is a more difficult proposition since in order to know the NOI you must know the expense structure of the comp, which is difficult to gauge indeed.
p>As such, I suggest that the best way to understand the trends in any marketplace is just to ask a commercial banker or a good appraiser, whose job it is to know the going CAP Rate.
While the NOI is a valuable tool in being able to assess the income potential of an investment, and in combination with the CAP Rate allows us to estimate the value of any income-producing asset, neither gives as a clear understanding of our bottom line relative to the type of financing we arranged for this transaction. As I stated earlier, the NOI accounts for all of the expenses except for one – financing costs.
Obviously, if we were to pay all cash for a building, then there would not be a mortgage or a mortgage payment. In this case the NOI is in fact our bottom line – the dough in the bank at the end of the month.
However, most of us will have to utilize some amount of leverage in order to acquire assets, and as such we will have debt service obligations, and since debt service is not included into the NOI calculation, we must add one more step to our analysis. Namely, we must subtract the cost of our mortgage from the NOI in order to arrive at Cash Flow
Cash Flow = NOI – Debt Service
Cash Flow is the single most important metric relative to long-term investments. Cash Flow, as far as I am concerned, is the true measure of the investment. We acquire income-producing assets for the purpose of generating passive cash flow, because we view passive cash flow as the more stable alternative to earned income. Therefore, the entire purpose of acquisition of income-producing real estate is relative to its capacity to “throw-off” passive cash flow.
An important distinction to be understood is that the terms of the underlying financing have a profound impact on the Cash Flow. For instance, a 4-plex which generates monthly NOI of $1,250, and is financed with a 30-year mortgage loan at 6%, can generate monthly cash flow of about $650, since the monthly debt service associated with this loan will be roughly $600. However, the same exact building financed with a 15-year mortgage loan at 7% will generate only about $350 of monthly cash flow, because the monthly payment in this case is much higher.
Another important way of analyzing the return on your investment is to consider your cash contribution as the entirety of the investment. In fact, this may very well be the most reasonable approach. After all, you may have bought that 4-plex we’ve been discussing for $144,000 dollars, but unless you paid cash for it, it can be said that your actual cash out of pocket investment is only the down-payment and closing costs…
The metric of Cash on Cash Return juxtaposes your cash investment against the cash flow achieved by the building you bought. The formula is:
CCR = Annual Cash Flow / Total Cash Investment
Thus, if you put down 20% ($28,800) and spent $1,200 on closing costs for a total cash out of pocket investment of $30,000, and the 4-plex cash flows $650/month ($7,800/year), then you’ve achieved a Cash on Cash Return of 26%:
CCR = Annual Cash Flow / Total Cash Investment = $7,800 / $30,000 = 26%
The IRR is likely the most sophisticated measure of investment return in real estate. Frankly, it wasn’t until quite late in my investing career and needed to track investment returns throughout multiple years and income in-flows and out-flows that I paid any attention to it. Cash Flow, CAP Rate, and Cash on Cash should be sufficient measurements of investment return for the vast majority of folks reading this. However, if you have money coming in and going out at various stages of the investment, the Internal Rate of Return is the only metric capable of giving you the complete answer. One article I came across that I thought stood out is by J Scott – one of my compatriots at BiggerPockets, who about 4 years ago wrote on the subject. In fact, his article was the best content on the subject in my opinion – until my fingers touched the keyboard that is…:)
Let us consider an investment opportunity which involves you buying an apartment complex for $3,000,000. The required down-payment is $600,000; the remodel will cost $400,000; and the closing costs, points, prorations, and various deposits total $100,000. Thus, to close on the deal you will need $1,100,000.
Now lets say that this project throws off $110,000 of Cash Flow in year 1; $113,000 in year 2; $117,000 in year 3; $120,000 in year 4; and $122,000 of Cash Flow in year 5. Further, let’s say that after 5 years you sell the asset for $3,300,000. Let’s say that the remaining balance on your debt is $2,250,000, in which case having sold for $3,300,000 you’ll be receiving $1,050,000 at closing. Also, at closing you are refunded $50,000 worth of deposits which you made at the time of acquisition. Thus, the total amount of cash coming to you at closing is $1,100,000.
The IRR formula is capable of taking into account all of the inflows and outflows and to reconcile them into the Internal Rate of Return. The formula is very complex, but the actual calculation is accomplished with ease in Microsoft Excel since the formula for IRR is standard – here’s what it looks like:
Notice that the opening balance is a negative number; think of it as money being taken away from you. Subsequently, years 1 through 5 represent the positive Cash Flow from the investment. And finally, the last item is the total cash distribution to you at closing. And as you can see, with the numbers being what they are, the apparent Internal Rate of Return on this investment is 9.14%.
You’ll find that the more sophisticated investors do want to know the IRR on any given investment, and this is specifically true of investments into a real estate syndicate, which is what I am involved with and the reason I use this calculation a lot. As I mentioned, I am not sure if IRR is entirely useful to you, but here you go J
Now – the DSCR you should know for sure! DSCR is a ratio that the lenders use to determine the relationship of the Monthly Debt Service (Mortgage Payment) to the NOI. Essentially, the lender wants to establish how easily you are going to be able to make your mortgage payment. The reason I am including DSCR into the article is because you need to know what your lender is thinking in order to be able to structure deals!
The formula is:
DSCR = Monthly NOI / Monthly Debt Service
Thus, if the lender allowed you to borrow money at a cost of $1,200 per month to finance your 4-plex which achieves a monthly NOI of $1,200, then the proportion would be 1:
DSCR = Monthly NOI / Monthly Debt Service = $1,200 / $1,200 = 1
This would mean that after you pay your mortgage, there would be nothing left; your cash flow would be $0. Naturally, lenders are not likely to entertain this scenario. More likely, lenders will require a minimum of 1.2 DSCR, meaning that your monthly NOI will need to exceed the mortgage payment by 20%. To figure out the maximum mortgage payment you will qualify for assuming a 1.2 DSCR, we invert the formula:
Mortgage Payment = Monthly NOI / DSCR = $1,200 / 1.2 = $1,000
Prior to approaching a lender for funding, you should research their guidelines relative to DSCR and make sure that your proposal falls within the scope of their requirements. No matter how much sense your project makes, it is not going to be approved if it doesn’t fit the guidelines
SO – HOW TO CALCULATE ROI ON INVESTMENT PROPERTY
Answer – as simple as the 3,000 words above. Well, may be not quite as simple as that. As I mentioned at the outset, what makes a good investment opportunity is a can of worms that holds much more than just numbers, and to learn what all is in that can I encourage you to consult the CFFU. However, understanding the logic and application discussed in this article will put you a leg up on your competition relative to being able to analyze the financial worth of an investment.
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