By: Allison Paz, Originations
Having a fundamental understanding of how success is measured is important for any industry. This especially holds true within residential real estate investing. The ability to estimate an investor’s potential return from an investment property is imperative to being able to maximize cash flow. Metrics which help to benchmark such success are cap rates and ROI.
Cap rate, or capitalization rate, often reflects the desirability of an income producing property’s future cash flow. It is calculated by dividing the adjusted NOI (net operating income) with the current market value.
|Cap Rate =||Adjusted NOI|
Adjusted NOI is the total annual income less operating expense less interest expense.1 Whereas, market value is what an asset would be worth if it was going to enter the market today3.
For example, if Angela was looking to purchase an investment property that had an adjusted NOI of $100,000 and the current market value of the property was $1,000,000, then the cap rate would equal as follows: $100,000/$1,000,000 = 10%. This would normally be referred to as a 10 cap. Angela would use the 10 cap as a basis in which to compare other properties.
While the cap rate is an important benchmark, it is not the only metric in which to weigh an investment decision. In our initial example, Angela is looking at a property with a 10 cap. As Angela continues to weigh this investment, she comes across another property with a 5% cap rate. While on the surface it may seem like Angela should invest in the 10-cap property, what if the property with the higher cap rate was an older building or situated in a dodgier neighborhood? This would make for a riskier investment, which often justifies a higher return, but comes with an added element of liability. In other words, it is important to not only understand the metric but be able to look at that metric in conjunction with other data points.
Return on investment, or ROI, is another vital calculation in which to understand how an investment property or portfolio is performing and compare it to other potential investments. Since this benchmark can be used to examine different aspects of a property, it is important to know which measurements are being used to calculate ROI.
In an all-cash transaction, calculating annual ROI is fairly straightforward. One would take the net profit of a transaction and divide that by the invested amount. For example, an investment property costs $100,000 all-in. The property can generate a monthly rental amount of $575, of which, $75 needs to go towards paying taxes and insurance of the property. The annual net profit of the property can then be calculated by subtracting $575 by $75 (monthly NOI) and multiplying by 12 (annual NOI).
In this case, the annual NOI of the investment property would be $6,000. In order to find the annual ROI, one would divide the annual NOI over the all-in basis, or $6,000/$100,000 = 6% ROI. 4Now, assume that you are going to use an investment loan to give you leverage and allow you to acquire the same property for $25,000 all-in. You are able to finance the property at a 5% coupon with a 30-year fixed rate. This would mean that you would have an interest and principal payment of approximately $429 per month. You would still be responsible for the $75 of taxes and insurance so your total expenses will be $504.
If the rental amount is $575 a month, you would subtract the $504 from $575 to get a monthly NOI of $70. You can then multiply that amount by 12 to get an annual NOI of $840. To find the annual ROI using leverage, you would divide that amount by the amount invested to get $840/$25,000, which produces an annual ROI of 3.4%.
In this example, it may seem that using leverage was not as advantageous as financing with all cash. However, the amount invested all-in with leverage was only a fraction (25%) of the all-cash purchase. This frees up 75% of investment capital and enables investors to acquire two to three additional properties if they would like to expand their portfolio and mitigate their risks across 4 properties instead of one. As always, cap rate and ROI will vary based on the amount of leverage and the rates. Regardless, it is important to use consistent metrics in order to maintain data integrity whenever evaluating a property and to keep in mind that metrics should be used in conjunction with other data points and not limited/isolated to one perspective.
CoreVest is the leading lender to residential real estate investors. We provide attractive long-term debt products for stabilized rental portfolios as well as credit lines for new acquisitions. For more information about how CoreVest can help you grow your rental and rehab business, please call Allison Paz at 949.647.4442 or email firstname.lastname@example.org.