Guest blogger Derek Dawson is the Founder and CEO of Dawson Property Management. Derek went to Florida State University and received a Bachelor’s of Science in Finance and Real Estate and has lived in Charlotte since 1994. In 2011, Derek founded Dawson Property Management and became the Broker-in-Charge. Derek has a passion for the property management industry and strives to use his experience, knowledge, and hard work ethic to satisfy all of his clients to his best ability.
What’s a Good Return on Real Estate Investment?
Chasing after unrealistic rates of return is one of the main reasons newbies investing in real estate lose money. Very few folks understand how compounding works.
So, how exactly does compounding work? Essentially, compounding is whereby an asset’s earnings, from either interest or capital gains, are reinvested to generate additional earnings over a period of time.
Here’s an example to illustrate this better. Assume you’ve invested $10,000 at 10% for 100 years. Using the concept of compound interest, that would translate to a staggering $137.8 million.
At twice the rate of return, 20%, the same $10,000 investment would result into a whopping $828.2 billion. Now, that’s a lot of money!
Does the difference between a 10% return and a 20% return seem counter-intuitive? Well, that’s what geometric growth is all about.
This concept of compounding works equally well in real estate as it does in the sharemarket or with cash in the bank. For instance, a property worth $400,000 having a growth rate of 5% a year is worth $650,000 after ten years.
Bump up the rate of growth by two percent and it almost doubles to $787,000. In addition to boosting your property’s value, you can also benefit from charging higher rents.
How Do You Measure Return on Real Estate Investment?
The purpose of investing in real estate property is to make money. But exactly how do you make money? You can only make money if your investment is offering a good return on your investment.
So now, what is a good return on a real estate investment? Unfortunately, the answer isn’t as straightforward. To help you calculate the potential ROI, here are 3 most widely used methods.
1. Cash on Cash Return
Cash on Cash return is a widely used metric for determining the profitability of a real estate investment. It measures the annual return on your investment based on total cash investment and net operating income (NOI).
Suppose you’ve bought a rental property through a mortgage worth $350,000:
CoC varies depending on the method of financing. It’s higher when a property is bought via mortgage and lower when the same property is bought fully in cash.
Suppose you buy a property for a total of $350,000 through a mortgage. You pay a down payment of $70,000 (or 20%) and rent the home for $1,800 per month. Then the annual property expenses add up to $4,000.
In this case, Cash on Cash return becomes 25.1%. (12 x $1,800 - $4,000)/$70,000.
When the property is paid fully in cash, then CoC becomes 5.0%. (12 x $1,800 - $4,000)/$350,000.
So, what’s a good ROI for investment properties with regards to CoC return? Experts generally agree that a good Cash on Cash return is anything above 8%.
2. Capitalization Rate
Also called the cap rate, capitalization rate determines an income property’s return based on the net operating income (NOI). It’s another widely popular metric for calculating the ROI on a rental property.
Unlike Cash on Cash return, capitalization rate doesn’t vary with the method of financing.
Supposing you buy a rental property worth $500,000 and charge your tenants $3,200 per month. Furthermore, the annual expenses related to that property add up to $6,000.
The cap rate for that property will then become 6.5%. (12x$3,200 - $6,000)/$500,000.
Similar to the cap rate, a good CoC return is anything above eight percent and especially above ten percent.
3. Return on Investment
Also called ROI, return on investment measures the gain or loss generated on an investment relative to the amount of money invested.
It’s usually used to compare the efficiency of different investments, to compare a company’s profitability or used for personal financial decisions.
Suppose you buy an income property for $400,000 and pay an additional $15,000 in related expenses. Then rent it out for $2,500 per month. The ROI for that rental property then becomes 7.2%. 12x$2,500/($400,000 + $15,000).
To know whether a real estate investment is profitable or not, you need to know what a good ROI is. Again, there is no straightforward answer. Experts will give you varying answers.
ROI varies on investment risks, the location, and the investment property size. Some investors would appreciate a 6% ROI, while some would be happy with anything above 40%. Generally speaking, avoid anything below 15%.
4. The One Percent Rule
This tool quickly filters and evaluates the potential of a real estate investment. According to the rule, gross monthly rent should be at least one percent of its final price.
For example, for a house worth $300,000 to be profitable, you would need to rent it out for $3,000 a month.
Numbers never lie. If you do your math right, you’ll have a pretty good idea of what your investment’s return will be.