Before acquiring any major asset, it’s important to know how you will measure its success and profitability over time.
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This is especially true for property investments, as there can be a large variance in how different types of properties perform despite shared qualities.
By being aware of key measurements, you can spot the risks and opportunities of holding the asset and ultimately make better, more profitable decisions.
Return on Investment
The most common metric for property investment is called return on investment (ROI). Simply put, ROI measures how much money you’ve made or lost on an investment relative to the amount of money you’ve put in.
ROI can be measured by dividing the net operating income (income – expenses) by the total investment.
For example, if your property earns $1,500 in net operating revenue each month, has $100 in monthly expenses, and you spent $100,000 on it, your return on investment would be:
ROI = [(1,500 x 12 months) – (100 x 12 months)]/$100,000 = 0.0168 = 16.80%
If you’re wondering what a good ROI would amount to, typically anything above 15% is considered as a good return on investment.
However, this is subjective and dependent on the individual’s risk tolerance and the properties’ unique qualities.
The capitalization rate (cap rate) is a measure of the yield on an investment. It’s fairly similar to return on investment, but instead of being concerned with the cash flow over a specific term, it only focuses on the property’s current value.
The capitalization rate is calculated by dividing the net operating income by the current value of the property. The net operating income refers to the annual income generated by the property. It doesn’t take into account the total expenses spent on acquiring the property—only the operating expenses (such as repairs, maintenance, etc.).
For example, if your property is currently valued at $200,000 and it generates $20,000 in net operating income each year, while having an operating expense of $2,000 per year, the cap rate would be:
Cap Rate = ($20,000 – $2,000 / $200,000) x 100 = 9%
As a rule of thumb, having a cap rate between 8 to 12% is preferred. But just like with the ROI, it’s important to remember that this metric varies depending on the market and other factors.
For example, if you’re looking to buy a property in another city, you may have to connect with brokers online like in the Joust online home loans marketplace to get a better insight into the current real estate situation in the city.
This way, you won’t overpay for a property or buy a house in an area that’s not as profitable.
Cash on Cash Return
Another common metric used to measure the success of property investment is cash on cash return (CoC return). This metric looks at the cash flow generated by the property, without considering the effects of expenses, leverage, and taxes.
The cash on cash return is calculated by dividing the pre-taxed cash flow of the property by the total cash invested, multiplied by 100.
For example, if your property generates $10,000 in cash flow each year and you’ve invested $100,000 of your own money into it, your cash on cash return would be:
CoC Return = ($10,000 / $100,000) x 100 = 10%
This metric is often used by real estate investors to quickly compare different investment opportunities. This is because it strips away all the complex financial factors and simply focuses on the cash value of the property.
A good CoC Return falls within the range of 8 to 12%.
Another way to measure the success of a property investment is through capital appreciation. This looks at how the value of the property has increased (or decreased) since you’ve acquired it.
This metric is calculated by subtracting the purchase price of the property from its current value. For example, if you bought a property for $100,000 and it’s now worth $150,000, your capital appreciation would be:
Capital Appreciation = $150,000 – $100,000 = $50,000
Unsurprisingly, the higher the capital appreciation, the better. However, it’s important to keep in mind that this metric can be affected by external factors, such as the current market conditions and its saleability.
Investment Audit by a Third Party
If you’d rather not go through all the hassle of calculating all these different metrics, you could always get a third party to do it for you.
Asset management companies can provide you with an in-depth analysis of your property investment. This includes (but isn’t limited to) a financial appraisal, market research, and opportunity and risk identification.
While this option incurs extra costs, having a second pair of eyes scrutinizing investment is never a bad thing, especially when it comes to major assets like real estate.