I am generally opposed to the “get-rich-quick” methods of real estate investment because they often assume self-management while ignoring your opportunity cost of time and the risks of high leverage. Besides, logic suggests, that when you uncover a goldmine you do not publish a map.
In real life, there is no secret way to attain real estate investing success. It requires hard work with good research and systematic analysis.
Here are some things about real estate investing that you may, or may not, know that may help you.
Real Estate Investment Does Provide Opportunities to Make Money
There are various ways to add value to real estate investment property, and thus real estate investing a profitable business.
- Real estate acquisition
- Development
- Financing
- Site analysis
- Controlling operating costs
- Innovative marketing
- Innovative property management
Business Goals You Might Consider
- Maximize long term wealth
- Short term financial goals like cash flow
- Develop or own only the highest quality properties in prestige locations
- Own the largest market share of a certain type of income property in a local market
Short Term Financial Goals You Might Consider
- Satisfy the requirements of the lender in terms of pre-leasing or debt coverage cash flows
- Satisfy the minimum required first year cash on cash returns required of investors
- Project minimum internal rates of return for the entire holding period of some minimum percentage
- Maintain occupancy levels above 95% in all portfolio properties
Popular Financial Analysis Decision Models
- Cash on Cash Return (CoC)
- Gross Rent Multiplier (GRM)
- Capitalization “Cap” Rate
- Internal Rate of Return (IRR)
Cash on Cash Return
Cash on cash measures the initial profitability of a rental property. The higher the better, and typically a first-year cash on cash return ranges from about 4% to 10%.
Formula: Cash on Cash = Before Tax Cash Flow / Cash Equity (Initial Investment)
Gross Rent Multiplier
Gross rent multiplier measures the ratio between annual gross rental income and sale price. Think of it as an indication of the number of years it takes the annual rental income to equal the price, so the lower the better. It is good for simple comparisons to other rental property opportunities but insufficient as a stand-alone number.
Formula: Gross Rent Multiplier = Purchase Price / Gross Rent
Capitalization Rate
“Cap Rate” is essentially a return on asset indicator of how much debt an income property can carry. The higher the return rate, the more debt a property can support, and hence the better the investment opportunity for the real estate investor. Sellers of income property, of course, prefer to sell at lower cap rates. Local markets dictate capitalization rate (there is no one-size-fits-all) but they typically run from about 5% to 12%
Formula: Capitalization Rate = Net Operating Income / Purchase Price or Value
Internal Rate of Return
The IRR model essentially calculates the average discount rate that equates all future returns over the projected holding period back to the present value of the initial equity investment.
It is the most frequently used measurement of projected holding period overall returns because IRR delivers in one number an investment return that integrates rental growth rates and property value appreciation.
RR should be used as a comparison to the real estate investor’s required rate of return for making capital allocation and initial investment decisions. An IRR can be before or after tax using before or after tax cash flows.
Software
Although you can make the calculations yourself on some hand-held calculators or in Excel, both your time and money would be better spent if you invest in good real estate investment software that can quickly make the calculations for you.
