Let’s come to the point here, investment in immovable property means making money. Investors purchase residential property, rent them out to renters and in exchange earn rental profits. It is essential to estimate how much rental income you'll earn before you buy a rental property. It's not, though, the perfect indicator of productivity. You'll need to calculate the rate of return on a rental property to determine the actual profit. We'll show you in today's blog how to analyze the rate of return in real estate.
What is the rate of return?
Rate of return (ROR) is a metric which measures an investment property's current profitability. It can also be used for estimating the projected productivity of rental assets. For many reasons, ROR is a more precise measure of profit than rental income. First, the rate of return measures revenue or net income relative to the value or cost of the investment property. Secondly, ROR can take into account the various costs and expenses. As a result, net returns are calculated, as opposed to gross revenue.
This obviously leaves real estate investors wondering: What is the rule for the rate of return? The reality is that there isn't a standardized ROR scale. There are different types of ROR, among other considerations, depending on the finance process and measurement purposes. The three most widely used in a study of return on real estate return on investment, limit rate and interest on return on assets.
1. Return on investment:
In a return analysis, the first factor is the return on investment. Also known as ROI, it is always expressed as a percentage or a ratio. ROI is calculated as:
ROI= Annual Return/ Cost of Investment
As you can see, the return on the investment depends on two variables. Annual returns represent income generated from a rental property. It is measured as a compounded by 12 monthly income. Then, for calculating ROI, you should split your annual returns by the investment cost.
2. Capitalization rate:
If you plan to purchase a cash investment property, the cap rate is the ideal ROR metric for you. Cap rate, short for the rate of capitalization, calculates profitability relative to the fair market value of a property. Here is the wording for the cap rate:
Capitalization Rate= Net Operating Income/ Fair Market Value
You might have noticed something if you're an experienced real estate investor. The formulation of the cap rate is a derivation of the formula ROI. Although their principal variables differ, they are meant to represent the same concepts. ROI, for example, uses its numerator for annual returns. In comparison, the Cap limit uses net operating income (NOI).
Cash on cash returns:
If you buy an investment property with a mortgage like most investors, you'll need a better metric rate of return analysis. Buying a property with income through a loan will yield significantly different returns than buying cash. You will need the cash on cash return, or CoC returns for short, to measure your actual returns. As already mentioned, the cap rate does not consider the method of financing. In contrast, cash on cash return does precisely that.
Cash on Cash Returns= Annual Pre-Tax Flow/ Total Cash Invested
Just as the cap rate is derived from the formulation of ROI, CoC return is an extension of the formula of cap rate. Annual pre-tax cash flow may sound like a variable vastly different from NOI, but it's not really. Annual cash flow before tax is simply the difference between net operating revenue and debt service. Debt servicing applies to a mortgage's principal balance, plus interest. Cash on cash return also makes use of total cash invested as opposed to FMV. You will not compensate the house in full at the initial payment by using a mortgage to buy a home, as you can when buying it with cash.