Rental Property Return On Investment(ROI)
Real estate return on investment(ROI) gets easily confused with other real estate rate of return calculations. This article shares how it is really calculated and why its different from other real estate rate of return calculations.
What Real Estate Return On Investment Is NOT
Other real estate rate of return calculations that it may get confused with are cash on cash return, equity build up rate, rental yield, or even capitalization rate. These are all useful calculations as it concerns real estate, but they shouldn't be confused with an investor's true rate of return or return on investment.
Some of these calculations aren't really that closely related to ROI but because they have the term return or rate or yield in the name, jargon quickly gets lost in translation. The main differentiaion between ROI and these other calculations, is that ROI considers or factors in the time value of money into its calculation. That means that an ROI calculation will be as accurate in year 1 as it is in year 30. (if estimations and projections are accurate of course)
What Return On Investment IS
It's been explained the terms ROI can get confused with, but here are some terms that should be considered synonyms or the same thing as ROI or rate of return. Two terms come to mind and these are Internal Rate of Return and Annualized Rate of Return. These mean the same thing as ROI or return on investment.
The formula for calculating ROI or Internal Rate of Return is actually very complex and it isn't recommended that it be done with pen and paper. Rather, you should use modern technology such as a financial calculator, excel, or a rental property calculator like the one by IQ Calculators. Nonetheless, we believe it is important to understand how the calculation is made so that you can understand it.
The technical explanation for how IRR or internal rate of return works in real estate is this. Internal rate of return is that rate of return at which the present value of all future cash flows equals zero. That means the internal rate of return formula would look something like this.
0 = CF0 + CF1/(1 + IRR) + CF2/(1 + IRR) + CF3/(1 + IRR) + .......
Where CF = Cash Flow Per Period and IRR = Internal Rate of Return
Two important cash flows that can often get overlooked is the cash outflow associated with purchasing the investment property, and the cash inflow associated with the final sale of the investment property.
As can be seen from the formula, the further out in time the projection is made, the more difficult it will be to determine what the IRR that makes the present value equal zero will be. At that point, it will become a plugging exercise until you reach the IRR where present value equals zero and that could take a while. An investment property calculator should be able to do this calculation as quickly as your can enter your real estate estimates and projections.
Calculating Real Estate Cash Flow
So far, only the IRR calculation has been discussed, but this may beg the question "how is the CF or cash flow in the above formula calculated"? Calculating real estate cash flow may seem straight forward, but its actually a fairly complex calculation.
To calculate net cash flow, first calculate gross income by taking one month's rent times twelve, and then subtract any vacancy allowance you might expect. Vacancy allowance is just what it sounds like...it is a way to be conservative and adjust for possible problems finding people to rent to.
Next, you'll need to subtract estimated expenses from rent. There are many places expenses can come from but a few might include HOA fees, property taxes, property insurance, utilities, and repairs and maintenance. Projecting these is not always easy, but if you are able to find experts in each respective area, you might be able to get more accurate estimations. For example, talk to an insurance agent to get an estimate on property insurance. And property taxes can be easy to estimate by visiting the county tax assessor's office.
Once expenses are subtracted from gross rental income, this equals your EBITDA or earnings before interest, taxes, depreciation, and amortization. In order to calculate net cash flow, interest and taxes still need to be subtracted. Depreciation does not need to be subtracted because it is a "non-cash" expense. By "non-cash" expense, that means depreciation is an expense that is allowed by the IRS but doesn't cost actual money. However, depreciation will be needed to calculate income tax expense.
First, let's subtract the mortgage interest expense from EBITDA. Because mortgage interest is a pure expense that gets paid to the bank, this must be subtracted to arrive at net cash flow. A simple mortgage calculator should provide a breakdown of principal and interest in year 1 in order to make this much more simple.
Next, subtract depreciation expense. As was stated earlier, this isn't an actual cash expense, but it needs to be subtracted before property income taxes can be calculated. (After taxes are calculated, depreciation gets added back in) Once depreciation is subtracted, multiply the result by your estimated marginal tax rate. This result is an estimated property income tax in year 1. After subtracting the property tax expense from income, add depreciation back to your income.
This is almost the final net cash flow calculation but there is one more thing to factor in. That one thing is mortgage principal. Mortgage principal is not considered an expense since principal payments go towards a property's equity. And so it would seem unnatural to deduct principal payments from income and if this was a net income calculation, that would be true. But this is a "net cash flow" calculation and since principal is paid purely to equity(and not cash), it cannot be considered cash flow in the truest sense of the term. Therefore, it must be subtracted in order to calculate final net cash flow.
How does principal then get factored into the ROI calculation one may ask? The cash flow from mortgage principal payments will get factored in in the final cash flow which is the one where the investment property is sold.
Net cash flow can be confusing so here is a formula version of the calculation with the bullet points representing steps in the process:
- Gross Income(including vacancy allowance) - Operating Expenses = EBITDA(Earnings before interest, taxes, depreciation and amortization)
- EBITDA - Interest Expenses - Depreciation = EBTA
- EBTA x Marginal Tax Rate = Estimated Property Income Taxes
- EBTA - Estimate Property Income Taxes = Net Income
- Net Income + Depreciation - Mortgage Principal Payments = Net Cash Flow
Similar to an IRR calculation, net cash flow can also be time intensive, especially if you are trying to create net cash flow projections over time. Let an investment property calculator do the work for you.
Calculating the Initial Cash Outflow(Purchase) and Final Cash Inflow(Sale)
One problem with the internal rate of return calculation is that it must factor in ALL cash flows which includes the cash outflow from the purchase and the cash inflow from the sale of the property.
To calculate your initial cash outflow or cash invested in the property, just consider all cash that will initially be spent to acquire the property. This may include the down payment, renovation expenses, and/or brokerage and mortgage fees.
The cash inflow from the sale of the property is much more difficult to estimate or predict. In order to remain conservative, it may be a good idea to assume the investment property won't appreciate. Regardless of what you choose for the value at sale, the debt remaining on the property at sale, capital gain taxes, depreciation recapture expenses, and fees (just to name a few) will all need to be calculated in order to determine the final cash flow from the sale of the property. Not to sound like a broken record, but using an investment property calculator for this is a great way to save time and headaches.
Conclusion
We discussed what return on investment is and what it isn't and the next time real estate terms are thrown around, they will hopefully be more definable and distinguishable from return on investment. What makes ROI unique from other calculations is the factoring in of the time value of money. The time value of money aspect combined with calculating net cash flow makes the return on investment calculation something that is easier to do with a real estate investment calculator.