How to Measure a Good Rental Investment
|If you have been around the investing world at all, you have heard of ROI (return on investment). It is the most commonly used ratio for determining the value of an investment as it relates to the return you’ll experience on the money invested. In accounting terms: it indicates the percentage of invested money returned to the investor after the deduction of associated cost. In layman’s terms, it measures how much you are making on the money you invested. This will allow you to compare investments. In Real Estate, I use – Return on Cash.
Return on Cash equation is simple:
Annual NOI (Net Operating Income) – Debt Service (before taxes) / the total cash invested
Let us break down each part of this equation. This way you will understand where the numbers come from when analyzing a deal.
Annual NOI = Annual Operating Income – Annual Operating Expenses
What comprises operating income and operating expenses? Good question!
Operating income = all the income from the property. This includes rents, of course, but also things like laundry income, pet rent, luxury services such as dry cleaning pick up.
Operating expenses = all expenses of running the building (this includes utilities, repairs, maintenance, property management, landscaping, property taxes and insurance). You will note that debt service (the loan) is not included. Why is that? Because the debt is not directly related to the property’s “operation”. Debt will change depending on the owner
Debt Service = the loan payment(s) for the mortgage(s) on the property.
Total Cash Invested = the down payment on the loan, any repair or rehab costs that you initially put into the property, closing costs, etc.
Let’s take a look at the formula used in an example:
This is a 4 Unit building with 1 – 3 bedroom unit, 2 – 2 bedroom units and 1 – 1 bedroom unit. The building is fully occupied and rents are at market prices.
Purchase price = $385,000
Cash Invested = $96,250
Monthly Operating Income = $4020.65
Monthly Operating Expenses = $893.06
Monthly Debt Service = $1,353.68
(4020.65 *12) – (893.06 *12) = 37,524 – (1,353.68*12) = 21280 / 96,250 = .221
This would be a killer deal – because it will take less than 5 years to make back the investment.
When looking to get into a “rental” opportunity, I look for two things: Return on cash that was invested (using the formula above) and what the cash flow (cash money I put in my pocket each month) will be. The formula we use to calculate cash flow is called CADS (Cash after Debt Service).
The CADS formula is = NOI (which you will recall is Operating Income – Operating Expense) – Debt Service. This is calculated monthly.
Using the same example:
4020.65-893.06 = 3127.59 – 1,353.68.
Many commercial investors will only care about CAP rate, but will save that metric for another article. For me personally, I more care about what return I will see on the cash I have invested and how much money is going into my pocket each month. Basically, “Show me the Money”!!!
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