Returns on tangible real estate
Tangible real estate offers returns that can beat the S&P 500 -- in part because of your ability to leverage it. In other words, you can take out a mortgage and increase your cash-on-cash return, leaving open the possibility of using your other funds to purchase more properties.
For example, if you bought that same $100,000 property mentioned above with a mortgage on which you put down $20,000 and still earned $8,000 in NOI, your cash-on-cash return is a whopping 40%. But your mortgage interest would be added to your cost basis, meaning your profit wouldn’t be quite as high when you went to sell as it would be if you had paid with cash.
A property’s capitalization rate, or cap rate, is another way to benchmark a particular neighborhood and/or asset class. The cap rate is calculated by dividing net operating income by the sale price, purchase price, or current market value of the property.
You can also use the NOI and cap rate to calculate a property's market value.
Say you want to make an offer on an income-producing apartment building with an NOI of $50,000 per year. You know from recent commercial appraisals and market research that the average capitalization rate of comparable sold properties in the neighborhood is 7%. That makes the market value of the building about $714,285 (divide $50,000 by .07 to arrive at this number).
If you paid for the building in cash, you would earn 7% on your money each year with income from rents. If you buy the property for $600,000, you’d get a steal -- that's a below-market price based on the building's NOI for the neighborhood.
The average cap rate for an apartment building in a neighborhood may be different than it is for an industrial or retail property. Each asset class may have a different standard for the area.
Returns on REITs
REITs let investors diversify their investment portfolios without running and managing a property themselves. REITs, which often own large developments and apartment complexes, must pay 90% of their income as dividends to shareholders. This raises the return over time -- even into the double digits. Private REITs can be risky and don’t have the same regulations as publicly-traded REITs, and investors should exercise caution when considering them.
REIT returns are more volatile than tangible real estate -- they go up and down over short periods -- because they're publicly traded. According to industry group NAREIT, though, the average compounded annual growth rate for REITs over the past 20 years is 9.9%.
Stick to your long-term goals
The best method for investing is to choose a strategy for achieving your long-term goals and stick with it through thick and thin.
Your returns in real estate will be determined by prudent buying, selling, and management decisions. And your ability to stick it out through various ups and downs is crucial, too.