To decide if it's worth buying a rental property, an investor must project its Return on Investment, which incorporates two variables: Cash Flow and Appreciation.
Cash on Cash Return
Your before-tax cash flow (BFCF) is calculated by subtracting total rental income of the property minus the total expenses. When you divide that by the amount of capital invested you get the Cash on Cash return.Cash on cash return helps to measure the financial performance concerning how it generates cash flow but does not include appreciation. To calculate the full return you need to add the appreciation.
Total Return on Investment
The total return on investment (TROI) offers a complete measure of the financial performance of a property because it takes into account the amortization and the appreciation generated over time.Total ROI = (BTCF + Net Sales Proceeds – Initial Cash Investment) / Initial Cash InvestmentTo calculate the TROI, the BTCF must be projected for each year of expected property, as well as the product of net sales from the sale of the property.
Sample Projection
For example, assume we buy a $150,000 property using $30,000 cash and getting a loan for the rest, and that we plan to sell it in five years with an average annual expected appreciation rate of 4% per year and a cash flow of $3,000 per year. After five years our $150,000 property would be worth $182,498, and our mortgage balance would be $111,665. Let’s also assume that our selling expenses total 5% of the sales price, or $9,125.The Cash on Cash, in this case, would be 10% ($3,000 / $30,000).Using the figures above, our net sales proceeds from the sale of the property in year five would be $61,708 ($182,498 – $111,665 – $9,125). Additionally, lets consider that the before tax cash flow after five years would total $15,000 ($3,000 x 5) assuming no annual increase in rents. Now our TROI formula would look like this:Total Return on Investment = ($15,000 + $61,708 – $30,000) / $30,000 = 156%.If we divide that per the 5 years would be 31.2% annually. By projecting a property’s future cash flows and appreciation, you can calculate the potential gains on your initial cash invested (down payment). Of course, other metrics and ratios can also help calculate returns of property investments, but these are the main ones to get acquainted with as you begin your journey as a real estate investor.
