While you don't need to be a mathematical genius to be a real estate investor, it does help to have a working knowledge of a few important numerical concepts. For example, knowing how to calculate the cash flow of potential rental properties can help determine whether a particular rental property would make a suitable investment or not.
Another concept all real estate investors should know is how to calculate investment returns -- that is, how much money your property is generating. However, there are several ways you can calculate rental property returns, and the best method for you to use depends on what you're trying to figure out. With that in mind, here's an overview of three ways you can calculate investment property returns -- capitalization rate, cash-on-cash return, and total return -- and when each method might be useful.
Capitalization (cap) rate
Capitalization rate, also known as cap rate, refers to a property’s net income as a percentage of its market value. For the purposes of this calculation, the purchase price of the property is often used as its market value, especially if it was acquired within the past few years.
Here’s an example of how this would work. Let’s say that you spend $100,000 to acquire a rental property that generates a total of $12,000 in rental income each year. After paying the property’s operating expenses like taxes, insurance, and maintenance (but not any mortgage payments), the property’s net income is $8,000. Dividing this amount by the property’s cost gives you a cap rate of 8%.
Cap rate can be useful for a few reasons. For starters, it could be an apples-to-apples way to compare potential rental properties that may have different financing structures, since it doesn’t take debt repayment into account. For example, if your lender wants a 15% down payment on a single-family property and a 25% down payment for a duplex, using the expected cap rate can help you determine which is the better deal relative to its rental income potential.
In addition, cap rates are often used to value commercial properties. As an example, let’s say that you know that rental properties in your area are selling for an average cap rate of 8%. If your property earns net income of $10,000 per year, you can use the cap rate calculation to determine the property’s approximate market value.
As I alluded to in the last section, lenders may finance different properties in different ways. Down payments and reserve requirements can be different depending on the number of living units a property has, the age of the property, and other variables.
One way to determine which property will produce the best return on your money is to calculate the cash-on-cash return. If you have several properties in mind, all with different prices and layouts, this can be the best metric to determine which property will cash flow the best.
Here’s an example -- let’s say that you are considering two properties:
- A single-family property for $100,000. Your lender requires a 20% down payment, and including closing costs, it will cost you $25,000 to acquire the property. The property can be reasonably expected to rent for $1,000 per month, and all of your expenses, including the mortgage payment, are estimated at $800 per month. So the property will produce net income of $200 each month.
- A duplex for $160,000. Your lender wants 25% down on this property, and including closing costs, it will cost you $45,000 to acquire this property. You expect it to rent for $1,600 per month, and your monthly expenses are estimated to be $1,300. So the property produces net income of $300 per month.
The first property generates cash flow of $2,400 per year. Based on the $25,000 you spent to acquire it, this translates to a 9.6% cash-on-cash return.
The second property generates cash flow of $3,600 per year. Based on the $45,000 you spent to acquire it, this translates to an 8% cash-on-cash return. So the first property can be expected to generate more income relative to the amount of money it costs you to acquire it.
Total return and internal rate of return (IRR)
Cap rate and cash-on-cash return are both income metrics. However, it’s important to remember that income is only one of the two ways investors make money from real estate -- equity appreciation is the other.
Total return is a combination of income and equity appreciation. For a simplified example, if you pay $100,000 in cash to acquire a property and it generates net income of $6,000 in a year and increases in value by $5,000, you have a total return of $11,000, or 11%.
Total return is best used as a long-term metric to evaluate your investment’s performance after you sell it. Let’s look at a slightly more complex example of how this works.
We’ll say that you buy a $100,000 rental property, but that you buy it with a mortgage and pay $25,000 out of pocket to acquire it. After five years, you decide to sell the property. Over your entire holding period, the property produces net rental income of $15,000 and you sell it for $120,000, $20,000 more than you paid. So your total return over the five-year period is $35,000. This translates to a 140% total return over five years, based on your $25,000 investment.
To annualize a total return, which is the most useful way to use this metric, take 1 divided by your holding period in years to determine your time factor. In this case, 1 divided by 5 gives a factor of 0.2. Take the total return, expressed as a decimal (in this case 1.40), add 1, and raise it to the power of this factor. The calculation should look like this:
Annualized return = (total return + 1)1/years = (1.40 + 1)1/5 = 1.191
Finally, subtract one from the result and convert back to a percentage:
As you can see, this investment would have produced a 19.1% annualized total return. This can help you assess how your investment performed, especially if you have other real estate investments, stock investments, or other investments that you’ve held for various time periods.
Internal rate of return (IRR) is often used in real estate investing and is similar in nature to annualized total returns. The mathematics of IRR are beyond the scope of this article, but here’s a great discussion on IRR, and there are tons of great IRR calculators available online.
Which is the best metric to use?
As you can see, these three metrics are all useful for different reasons. For example, capitalization rate can be used to assess the market value of properties, cash-on-cash return can help you compare different potential investment properties, and total return can help you assess an investment's performance including equity appreciation.
The best metric depends on the situation. As a savvy real estate investor, you should have all of these in your analytical toolkit.