Investment returns in real estate are really comprised of two pieces: operating positive cash flows and long-term appreciation. However, in today’s world, even though it probably will come, we cannot count upon and should not consider long term appreciation of real estate. That leaves positive operating cash flows as our primary source of investment return. Let’s call this: “earning money the old fashioned way.”
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How do we calculate our returns and how do they compare to other investments where we could place our hard earned cash equity dollars? It is quite straightforward to calculate our investment returns, unfortunately few people do this leaving many a buyer to make poor real estate choices.
“Cash on Cash return” is the most important measurement. While the price is important, one’s actual cash equity investment is the vital issue. Look at every dollar invested to figure out the percentage yield return on the equity cash investment. For example, CDs offer 1.5 percent, bonds are at 4.5 percent, and stocks hit at 7.5 percent. Real estate is generally high risk, so we will want fairly high returns to compensate for the risk.
If one is buying a $200,000 investment property they probably put down 25 percent or $50,000 plus another 5 percent or $10,000 for closing costs, loan fees and rehab costs. The mortgage is $150,000 and a buyer’s cash equity is $60,000 from the start. Again, the property price of $200,000 is important too, but how much cash equity one invests is much more important.
Using a conservative estimate, depending on the local market, that property might generate $1,800 per month in rent and have 33.3 percent operating expenses ($600) leaving a net operating income of $1,200. Subtracting the monthly mortgage payment of $900 leaves $300 monthly cash flow or $3,600 per year.
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Divide that $3,600 by the $60,000 of cash equity for a first year cash on cash return of 6 percent. It should increase a little each year as rental income increases, as do general expenses, but the mortgage stays constant.
That 6.0 percent is a pretty fair return for real estate and of course there hopefully will be some long term appreciation, tax benefits and a little more yield from the mortgage balance pay down via amortization of the loan.
It is stunning how many real estate buyers fail to do this simple calculation and buy properties with minimal or negative cash on cash returns – to their own financial detriment. Make sure you take a good look and a conservative approach to real estate investing for your own long term benefit.
Go for the Cash Flow
As a final note, buyers will find prize properties, like at the beach or fancy condos, usually have very low or negative returns. Skip those! It is the moderately priced units that have decent cash on cash returns.
Leonard Baron, MBA, CPA, is a San Diego State University Lecturer, a guest blogger on Zillow, the author of “Real Estate Ownership, Investment and Due Diligence 101—A Smarter Way to Buy Real Estate”, and loves kicking the tires of a good piece of dirt! See more at ProfessorBaron.com.