Are you wondering how to calculate return on investment for your real estate property? You probably already know that real estate investing is one of the most profitable and popular investment opportunities.
If you’re like most people, however, the nuances of real estate investing and figuring out how to calculate return on investment may still be somewhat unclear to you.
Too often, I see beginner real estate investors act like a pack of hungry animals, letting their emotions hijack their minds. They don’t make the right decisions when they invest in real estate, because they don’t know how to. Usually, fear of missing out and greed kicks in and gets in the way of smart investment decisions.
People will just listen to random strangers about what they should invest in, and they won’t find out for themselves by doing their own proper research. And that’s a huge part of the problem.
This is how the poor and middle class “invest”. They blindly go in with no real understanding of investing and no real strategy. If there is any thinking involved, it’s usually based on an unstable stack of groundless assumptions.
You probably know how it ends when people invest without first understanding what they’re investing in. It’s not a happy ending. It’s devastating to see people get stuck in investments they don’t understand. Why? Because many people end up losing everything.
How many people do you know who invest like this? We see this happen all the time in the stock market, cryptocurrency, and real estate.
It’s unfortunate that people invest in things they don’t understand and lose all of their money, but it’s true that it happens a lot. And again, it’s largely because people don’t comprehend what they’re investing in or know what they need to look out for.
My goal is to help you understand how to calculate return on investment for one of the more popular forms of investing out there: Real estate investing.
But first, let’s get some of the basics out of the way.
What Are The Different Types of Real Estate Properties?
Real estate is a common favorite investment among wealthy investors. There are actually only a small handful of investments the rich invest in such as the stock market, businesses, tax lien certificates (more on this in a moment), and real estate.It’s tangible, it’s solid, it’s beautiful and it’s artistic, from my standpoint. I just love real estate. - President Donald Trump Click To Tweet
When you’re getting started in real estate, it’s important to understand the different types of real estate properties available in the market. Why? Because each type has its own advantages and disadvantages that an investor, like yourself, should evaluate. Below are some of the different types of real estate:
Residential Real Estate
Residential real estate is obviously one of the most popular types of real estate to invest in. And for good reason, because it includes smaller types of investment properties and it’s an easy place to start.
Residential properties include single-family homes, duplexes, triplexes, townhouses, apartment buildings, and vacation homes. These are properties are either sold to homeowners or rented out to tenants.
Commercial Real Estate
Commercial real estate properties are the next level up when it comes to real estate investing. This includes hotels, office buildings, retail stores, storage facilities, warehouses, shopping centers, industrial buildings, some apartment buildings that exceed the maximum number of units, and more.
Commercial properties are used for businesses, hence the name. It’s one of the less popular investment options among new investors because there’s a higher barrier of entry. A new real estate investor would likely go with an investment in residential real estate.
Another way to put it is, you need to have a lot of money to get your foot in the door and invest in commercial real estate. There are ways around this through crowdfunding and real estate investment trusts, but most people build up to this kind of investment.
Raw or Vacant Land
The last type of real estate property is raw or vacant land. This includes farmland, ranches, or vacant land that have or have not been occupied by commercial or residential buildings. In certain locations, the land itself has immense value.
This type of property is not one that many people are familiar with. But it’s popular among investors that are looking to develop properties, or profit from value appreciation through a long-term buy and hold strategy.
One major caveat to these types of properties is that they require extensive research before you can invest, because of the frequent changes in development on new lands as well as changes in the market.
The Top Two Ways to Generate Wealth Through Residential Real Estate
The top two ways to generate wealth through residential real estate investing are via cash flow and capital gains. Let me explain:
1. Cash Flow Investing
Cash flow is defined as money coming in or out of your real estate investment. When you buy a property and rent it out to a tenant, every month that tenant will pay you their monthly rent (that is your monthly rental income) for living at the property you own.
You can generate positive cash flow (or passive income) if your monthly rental income is greater than your monthly expenses. In other words, if the amount you pay to maintain the property and the mortgage combined is exceeded by what your tenant is paying you every month, you’re generating positive cash flow off the property you own.
So for example, let’s say you invested in real estate by buying a single-family home for $350,000 dollars. You put $70,000 down as your down payment and secured a mortgage for the remaining balance of $280,000.
A mortgage is a loan you can get from a bank to purchase a home. The mortgage is secured by the home, so it acts as collateral just in case you fail to pay the bank your monthly mortgage (or as they say, default on the loan). If that happens, the bank can sell your home and regain its losses.
Going back to the above example, let’s say you decide to rent out the property you’ve invested in, to a tenant. You charge the tenant $2,500, which is now your monthly rental income from the property. Each month, however, you’re only paying $1,500 in expenses, which includes mortgage, property taxes, insurance, etc.
This means that your total monthly cash flow is $1,000, because it’s your monthly income minus monthly expenses. $2,500 (the rent your tenant pays you) minus $1,500 (your property expenses) equals $1,000 in total monthly cash flow.
Each month you are earning $1,000 in cash flow (which is passive income) and your tenant is paying off your mortgage at the same time. Sounds great, doesn’t it?
2. Capital Gains Investing
Firstly, if the value of your property goes up in value over time (appreciation) and you decide to sell it, your profit is referred to as capital gains. Some people choose to go this route if they just want to buy and hold without renting out the property.
Secondly, if you buy a rental property that appreciates in value over time, you’re not only getting a monthly flow of rental income but you also have the option to earn from capital gains when you sell the property.
Thirdly, by buying and flipping houses, you can earn quite a nice profit. I’m sure you’re aware of how wildly popular this type of investing is today. People are buying low-priced homes and properties that have a lot of issues. When they fix it up, they’re working to increase the value of the home, and then sell it for a higher price. Flipping houses is another way to invest for capital gains.
How Do You Know if an Investment is Good or Bad?
Learn financial literacy. Period.
This is one of the main reasons why so many people claim investing is risky. It’s because they have no idea how to read financial statements, which is why Robert Kiyosaki always says “investing is not risky, it’s investors who are risky,” because they don’t understand the language of money.
This knowledge is one of the single largest factors that separates poor and middle-class investors from rich and wealthy investors. They play by understanding the rules of the game whereas the poor and middle class don’t. Poor or unwise investors often just “wing it.”
As exciting as it is to “wing it,” wealthy investors do not like to put that sort of risk on their shoulders. When rich people invest, they do their due diligence first.
If you want to figure out how to calculate return on investment for your real estate property, financial literacy is key and it’s the first thing you need to evaluate any real estate property or investment for that matter.
Most people just look at properties and come up with opinions based on what they see on the outside. But they don’t stop to think about what’s happening on the inside. Financial statements allow you to do just that and see the inside. You’ll be able to see the good, the bad, and the ugly.
As Robert Kiyosaki would say, it’s just like how a “doctor uses X-rays to look at your skeletal system, a financial statement allows you to look into an investment and see the truth, the facts, the fiction, the opportunities, and the risk.”
So where do you start?
Learn The Language and Terminology First
Think about a time when you traveled to a foreign country, like Japan, for example. Wouldn’t you agree that it would be difficult to navigate around Japan if you didn’t familiarize yourself with the language or learn the language first?
It’s the same with real estate. If you want to fully understand how to calculate return on investment for real estate properties, then there are some terms and real estate jargon you need to familiarize yourself with. Think of learning these real estate terms as learning the basics.
In general, more knowledge will help you learn how to calculate return on investment, and learning certain terminologies can help you understand what types of things could effect your return on investment.Financial literacy is one of the most important investor basics, especially if you want to be a safe investor, an inside investor, and a rich investor. - Robert Kiyosaki Click To Tweet
Robert Kiyosaki’s rich dad said it best, “You can’t tell from the building alone whether an investment is good or bad. You’ve got to look at the numbers. The numbers tell the story.”
What Is a Pro Forma and Why is it Important?
One of the first things you need to calculate your return on investment is learning how to review a pro forma. This is nothing more than a tool to help you see if a real estate investment has the potential to generate return for you.
It gives you the superpower to see into the future and look at the different possibilities for return on investment.
In other words, a pro forma is a type of financial statement for a real estate investment property. It can help you predict return or figure out how to calculate return on investment. It is similar to a cash flow financial statement that shows you your current income and expenses. But instead of showing you actual operating numbers, it shows you projected income and expenses.
Another way to think about it is, a pro forma helps paint a picture in your mind about what would happen to your return if you increase a tenant’s monthly rent and decreased expenses. Or what would happen if you increase a tenant’s monthly rent and decrease the vacancy rate.
It assumes different possibilities and scenarios to give you an idea of what return you could expect, similar to a weather forecast.
You should have a pretty good idea about what a pro forma is now but it doesn’t stop there. There’s more.
What’s on a Pro Forma?
The projected numbers on a pro forma will give you some context on whether or not a property is worth reviewing further or if you can just cross it off your list.
So let’s take a look at some real estate jargon you might not be familiar with.
- Cash on Cash Return: Simply put, this is the percentage of return you’re getting from your net annual cash flow. It’s calculated by dividing your net annual cash flow by the amount of cash you put into the property
- CAP Rate (capitalization rate): This metric shows you how profitable your real estate investment is. So another way to say it is, it’s how much potential return you should expect over the course of 12 months assuming you purchased the property with cash and not on a loan.
- Cash Flow: It is the amount that’s left over when you subtract money coming in as income and the money coming out as expenses and debt (like your mortgage). And the value can be negative or positive.
- Capital Gain: This is the difference between the price that you bought an investment property and the price that you sold it.
- Operating Expenses: This includes all expenses needed to operate the property.
- Net Operating Income (NOI): This is what’s left over when you subtract the total collected income and the total operating expenses.
What I have given you here is a simplified overview of the terminology you need to know. Now, this doesn’t mean that you need to be a real estate genius to figure this out.
But I do recommend you dive deeper and invest in learning more about financial literacy as it is a crucial skill to learn if you are planning to make any future investments.
How To Calculate Return On Investment For Your Real Estate Property?
Now, for the question you’ve been waiting for, you want to know exactly how to calculate return on investment for your real estate property, right?
For the sake of simplicity, I’m going to introduce three best ways to figure out your investment property returns. And don’t worry, you don’t need to be Albert Einstein to understand these basic math calculations. If you understand addition, subtraction, multiplication, and division, then you’re good to go.
So let’s get started:
1. Cash on Cash Return
Cash on cash return is one of the simplest but one of the most important metrics to determine the return potential on a property. It’s a metric that is widely used in real estate to calculate your percentage return on investment because it’s easy for everyone to understand.
Here’s how you do the math. It’s simply the amount of physical cash flow you have earned after 12 months divided by the amount of physical cash you invested into the property.
CASH on CASH Return = (Positive Net Annual Cash Flow / Down Payment) x 100
Let’s refer back to the cash flow example earlier and add some numbers to this equation.
17% = (($1,000 x 12 Months) / $70,000) x 100
So your cash on cash return is about 17%. Now you might be wondering, “Is this a good percentage?”
The short answer is yes. The real answer is it depends on your personal investment strategy and what kind of return you’re looking for. Usually, the higher the cash on cash returns the better but a lower number isn’t necessarily a bad thing either.
If you want to learn more about cash on cash return, Bigger Pockets does a great job explaining the smaller nuances of this metric and other important things to consider.
2. CAP (capitalization) rate
This is the net operating income divided by the purchase price. Let’s take a look at an example. Using the same cash flow example, you spend $350,000 to buy a rental property and each year you generate a net income of $30,000 (rental income $2,500 x 12 months).
After you pay the property’s operating expenses like insurance, taxes, and maintenance, let’s say the property’s net income is $26,000. When you divide this value by the purchase price of the property, you get a CAP rate of about 7%
Keep in mind that mortgage is not included in expenses because the CAP rate doesn’t account for it. Below is what the equation looks like:
CAP Rate = (Net Operating Income / Purchase Price)
What is a good CAP rate? Good question. Here is a general rule:
The higher the CAP rate the lower the price of the property will be relative to its actual value. This is good if you are buying a property because it means your initial investment will be lower.
Likewise, the lower the CAP rate the higher the price of the property will be relative to its actual value. This is good if you are selling a property because it means the value of your property will be higher.
One way it’s used is to compare rental properties that have different down payment structures. For example, let’s say you were comparing the return potential of a single-family home and townhouse. Your bank (or lender) requires you to pay a 15% down payment for the single-family and a 25% down payment for the townhouse.
Using the CAP rate you can compare which property will be a better deal based on its return potential.
If you want to learn more about how CAP rate works, you can look here at investopedia.
3. Total Return and Internal Rate Of Return (IRR)
If you recall earlier, real estate investors invest for cash flow and capital gains. So far we’ve talked about cash on cash return and CAP rate which are both income metrics.
But we haven’t talked about how to calculate return on investment for capital gains (you’ll also hear people call it equity appreciation).
So for capital gains, people will refer to total return and internal rate of return metrics. For simplicity’s sake, total return measures the return potential that combines income and equity appreciation.
Internal rate of return measures the return potential in a similar way but accounts for the time value of the money invested. Now, as far as how they work and how they’re calculated is beyond the scope of this article. It’ll give you a headache if I showed you the math.
But if you choose to accept the challenge to learn more about it, then you can check it out at Investopedia.
Earlier, I said that residential real estate is one of the easier investment options because of the lower barrier of entry.
However, what if I told you there was an even easier alternative. One that doesn’t require you to have as much capital on hand to make a down payment on a real estate property.
They are called tax lien certificates.
Tax Lien Certificates: A Fuss-Free, High-Return Alternative To Real Estate
Many people who are interested in investing in real estate, but can’t afford to, choose tax lien investing, instead. Tax lien certificates are certificates sold by the government to investors to collect interest rates from homeowners. It’s similar to how the government collects taxes. And in certain situations, these tax lien certificates can be used to acquire ownership of a house at a very low price.
Here’s a brief overview of how it works. If you’re not already aware, the U.S. government is short on funds to maintain states and city infrastructure because they have millions of dollars outstanding in overdue property taxes from homeowners who will not or cannot pay their property taxes.
So what do they do?
They sell the right to collect homeowner taxes to investors through tax lien certificates. With this method, they can collect the money immediately to continue infrastructure operations instead of worrying about unpaid homeowner property taxes.
Now, what does this mean for you?
It means that when homeowners need to pay their property taxes, they’re no longer paying the government. They’re paying YOU. And in the event that they can’t pay their property taxes, you also reserve the right charge absurdly high-interest rates, which you can collect. So the longer they take to pay their taxes, the higher your ROI, because you’re collecting the interest. Makes sense, right?
The great thing about tax lien investing is that you don’t have to do anything. You don’t have to deal with tenants, home repairs, or anything like that. Imagine what it would be like to never worry about the hassles of renting and tenants when you can just sit back, relax, and watch your money flow in every month.
Do You Want To Learn How You Can Collect Taxes Just Like The Government?
If you’re interested in learning more about how tax lien certificates work and how you can leverage property owners who don’t pay their property taxes for great returns on investment, join me at an exclusive live-stream event I’m hosting in Las Vegas to reveal secrets of the rich and my top investment strategies.
This event is a millionaire investment opportunity like no other. And it’s only for serious people who are looking to become sophisticated investors and want to make 24%, 36% or even as high as a 58% return on their investments.
If you want to find out how tax lien certificates work and you think you have what it takes to become one of those highly sophisticated investors that collect handsome interest rate checks, then click here to access my exclusive live-stream event now.