Anyone involved in real estate investment, from the entrepreneurial veteran to the newbie looking to get into the game, has a common question at the start of the process: What will be the return on my investment? That is, after all, the reason people get involved with investment properties in the first place.
To reach the bottom line answer to the bottom line question, there are two rate-of-return calculations worth exploring. While one is simple and the other complex, they both provide the guideline to help investors determine their next move.
For most entrepreneurial investors, the cash-on-cash calculation is the way to go. It’s simple and provides an easy-to-understand cash flow outcome. In basic terms, cash-on-cash means subtracting expenses and debt services from gross income. The answer is the annual return.
Using a potato chip analogy, if I throw a bowl of potato chips into an investment, I need to know how many potato chips will be thrown off in a year for a rate of return for that investment.
In dollars and cents terms, the annual amount earned from an investment ($6,000) is divided by the amount of the initial investment ($100,000). The answer is then multiplied by 100 to get the cash-on-cash rate of return (6%).
The internal rate of return formula adds a complex spin to the calculations. In essence, the formula looks at the net present value of either the negative or positive cash flow that comes out of a specific property. If the internal rate of return is higher than your floor number, then it’s a good investment. If it’s below, then that is not an investment you should be making.
While that certainly seems logical, the formula grows in complexity because it uses an assortment of variables, such as depreciation and appreciation. Because some of these variables change with time and other outside forces, they cannot be firmly defined with a consistent number value. As a result, the internal rate of return cannot be calculated analytically and is instead achieved through trial and error or computer software.
This doesn’t go to say, however, that the internal rate of return doesn’t have a place in real estate investment. Using this formula is especially valuable when determining if a property should begin a new operation or whether it should expand/upgrade an existing one.
To help navigate the ups and downs of real estate investment, it’s always a good idea to work with a team skilled in both rates of return calculations, available properties, and client needs. Morris Southeast Group is able to provide the professional guidance you need before, during, and after you make your investment.
For a free consultation or to learn more about our property management, investment opportunities, and/or other services, call Morris Southeast Group at 954.474.1776. You can also reach Ken Morris directly at 954.240.4400 or via email at firstname.lastname@example.org.