Every real estate investor wants to make a profit! After all, it is the main reason one decides to spend their hard-earned money in order to generate a steady flow of income. Since you can’t manage what you can’t measure, there are several ways to calculate your profits.
But for those starting on their road to passive investing, there are 3 key and easy-to-understand ways to measure profits: Return on investment (ROI), capitalization rate (cap rate), and the 1%–2% rule.
Keep reading to discover what these different measurements are and how do you use them
1. Return of Investment (ROI)
Return on Investment (ROI) is a metric used to evaluate how well an investment has performed over a certain period of time. ROI is expressed as a percentage and is calculated by dividing an investment’s net profit (or loss) by its initial cost or outlay.
ROI is a popular metric because of its versatility and simplicity. Essentially, ROI can be used as a rudimentary gauge of an investment’s profitability. This could be the ROI on a stock investment, the ROI a company expects on expanding a factory, or the ROI generated in a real estate transaction.
The calculation itself is not too complicated, and it is relatively easy to interpret for its wide range of applications. If an investment’s ROI is net positive, it is probably worthwhile. But if other opportunities with higher ROIs are available, these signals can help investors eliminate or select the best options.
The return of investment formula divides the annual cash generated by your property after you account for your operating expenses and the mortgage payment by the total amount of money you invested. It looks like this:
ROI = Annual Return/Total Investment
For example, say you are investing in a property of $100,000 that generates $10,000 before debt service. With a down payment of 25%, your total investment would be $25,000. The loan is $75,000 over 15 years at 3.75% for a monthly payment of $545.42 (principal and interest, or P&I).
$3,454.96/$25,000 = 0.13819 or 13.819%
A rental property with a higher ROI is typically the best investment. By using different down payment amounts, you will see the ROI change and you can decide how best to leverage your investment.
Investors focused on maximizing ROI will want to use as little money down as possible despite the lower annual return. That said, we would advise investors to take some degree of risk by staking out good equity in the event that their market is seeing appreciation rise year over year. Higher down payments also generally receive more favorable rates from the banks.
2. Cap Rate
The capitalization rate (also known as cap rate) is used in the world of commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property.
While the cap rate can be useful for quickly comparing the relative value of similar real estate investments in the market, it should not be used as the sole indicator of an investment’s strength because it does not take into account leverage, the time value of money and future cash flows from property improvements, among other factors.
There are no clear ranges for a good or bad cap rate, and they largely depend on the context of the property and the market.
This measure is computed based on the net operating income (NOI) generated by the property before the debt service (P&I) by the property value or its asking price. The formula looks like this:
Cap Rate = NOI/Property Value
Debt for the mortgage payment should be excluded from the cap rate calculation because investors leverage property differently.
For example, say that you’re looking at a property with an annual gross income of $24,000 per year. If your normal operating expenses are 50% of your annual gross income, the NOI will be $12,000 per year. If the property has an asking price of $240,000, the projected cap rate will be 5%.
$12,000/$240,000 = 0.05 or 5%
Cap rates are going to be different depending on the market you are looking to invest in. For example, Nashville, Tennessee is going to be different from Stowe, Vermont. Generally, the higher the cap rate, the better the investment since the potential return is going to be higher, all things being equal.
That said, if there is a property with a cap rate outside the norm for the market, take some extra time and dig into the due diligence. What is it that sets that property apart? While it may not always be an indicator of a problem property, it does merit some more investigation. You may have found a diamond in the rough — or you may have found a dumpster fire.
It is wise to continually evaluate your cap rate. If the property values drop, if rents get depressed, etc., then you need to evaluate what is affecting your cap rate and your investment.
3. The 1%–2% Rule
The 1%–2% rule is an investing strategy where an investor risks no more than 1% or 2% of their available capital on any single trade. To apply the 2% rule, an investor must first determine their available capital, taking into account any future fees or commissions that may arise from trading.
This also means that after all expenses are paid, you will net 1% or 2% of the purchase price of the property each month. In other words, if you buy a $100,000 property, you net $1,000 a month after you have paid all the expenses.
In the event that market conditions change, an investor may implement a stop order to limit their downside exposure to a loss that only represents 1%-2% of their total trading capital. Even if a trader experiences ten consecutive losses, using this investment strategy, they will only draw their account down by 10%-20%.
Final Thoughts
Regardless of the formula you use to evaluate a property’s potential, these formulas are going to be tossed around the investment world. These are good things to know so that you can speak with some understanding with possible buyers and sellers.