Deal Or No Deal: Uncover the Truth About Your "Deal" With These Real Estate Investment Metrics

In real estate investing there is often a gut feeling that draws an investor to one property or another. While it’s important for a house to pass an investor’s eye test, it’s also important for an investment property to meet the investor’s needs from a numbers perspective too.

How do you know if a property you’re interested in is going to give you what you’re looking for from a financial point of view?

That’s where investment metrics come in – your secret weapons for analyzing the true earning potential of a real estate investment. There are several investment metrics that are used to measure investment performance. We’ll take a deep dive into three that are most commonly used so you can add these to your investing tool belt and analyze deals like a savvy investor.

1. Cash Flow:

Cash flow is often considered the lifeblood of any rental property. It is one of the fundamental investment metrics in real estate investing because it measures the net income generated by a rental property after deducting all operating expenses. It provides investors with insights into the property's ability to generate positive income and cover ongoing expenses, such as mortgage payments, property management fees, maintenance costs, and more.

Example: Let's consider a rental property with the following financials:

• Gross Rental Income: $2,500 per month

• Operating Expenses (including property taxes, insurance, maintenance, property management fees): $1,800 per month
  

Cash Flow = $2,500 − $1,800 = $700 Cash Flow

In this example, the property generates a positive cash flow of $700 per month.

How to Use Cash Flow:

A. Assessing Profitability: Positive cash flow indicates that the property is generating income beyond its operational expenses. This surplus can contribute to covering mortgage payments and building a financial buffer.

B. Budgeting and Planning: Cash flow is a crucial tool for budgeting and planning. It helps investors understand how much income they can expect to receive each month and whether it's sufficient to cover all expenses.

C. Risk Management: Regular positive cash flow acts as a buffer against unforeseen expenses or periods of vacancy. It enhances the property's resilience to market fluctuations and economic downturns.

D. Investment Decision-Making: When comparing potential investment properties, evaluating their cash flow helps investors make informed decisions. A property with consistent positive cash flow is generally considered a safer and more lucrative investment.

2. Cash on Cash Return (CoC Return):

CoC return focuses on the cash you actually receive from your investment, not the total profit that includes financing. It allows you to compare the direct return on investment between different properties, even if they have varying purchase prices or financing structures. A higher CoC return indicates a better cash-generating property.

It's calculated by dividing your annual pre-tax cash flow (income minus expenses) by your total cash investment (down payment + closing costs + any other out of pocket costs you initially invested to make a property ready to rent).

Example: Let's say you purchase a rental property for $200,000. After factoring in closing costs and your initial out of pocket make ready expenses, your total cash investment is $55,000 (20% down payment + closing costs + out of pocket make ready expenses). The property generates an annual pre-tax cash flow of $10,000.

CoC Return = ($10,000 / $55,000) × 100 = 18%

In this example, your CoC Return is 18%, indicating that for every dollar invested in cash, you're earning a 18% return annually.

How to Use CoC Return:

A. Comparison Across Properties: CoC Return allows you to compare the direct return on investment between different properties, even if they have varying purchase prices or financing structures. A higher CoC Return generally signals a better cash-generating property.

B. Assessing Investment Performance: If you have multiple investment opportunities, CoC Return helps you evaluate and prioritize based on the potential cash returns.

C. Setting Investment Goals: Investors often have specific targets for CoC Return based on their risk tolerance and financial objectives. This metric aids in setting realistic goals and identifying properties that align with those goals.

3. Payback Period:

Payback Period is a financial metric that helps investors assess how long it will take to recover their initial investment in a rental property through the generated rental income alone. It is a valuable tool for understanding the time frame required to recoup the upfront costs associated with the property purchase. A shorter payback period suggests a quicker return on your investment.

It's calculated by dividing your total cash investment by your annual pre-tax cash flow.

Example: Consider a real estate investment with the following details:

• Total Cash Investment (down payment, closing costs, and initial expenses): $60,000

• Annual Pre-tax Cash Flow: $12,000
  

Payback Period = $60,000 / $12,000 = 5 years

In this example, the Payback Period is 5 years. This means it would take five years for the investor to recoup their initial investment through the rental income alone.

How to Use Payback Period:

A. Assessing Investment Return Speed: The Payback Period helps investors understand how quickly they can recover their upfront investment. A shorter payback period is generally desirable, indicating a quicker return on investment.

B. Comparing Investment Opportunities: Investors can use the Payback Period to compare different investment opportunities. A property with a shorter payback period may be considered more attractive, especially if other factors like risk and market conditions are similar.

C. Aligning with Investment Goals: The Payback Period aligns with an investor's financial goals and risk tolerance. Some investors prefer shorter payback periods for a faster return, while others may prioritize long-term appreciation.

Remember: Don't rely solely on one metric! A comprehensive analysis using a combination of these tools will paint a clearer picture of a property's true investment potential. By wielding these metrics effectively, you can make informed decisions, separate good deals from bad, and navigate the exciting world of rental property investment with confidence.