How do I figure out my return on investment

Question

Hi all,

I am new to investing, and am about to buy my first real estate investment. I am trying to figure out how to calculate my return (cash on cash?/after tax), and have had a couple different people tell me different things, and have had trouble finding clear, concise information on the web for a financial layman like me. I'll simply tell you my financial and real estate details, and perhaps someone can show me a sample calculation so I can adjust it depending on the actual property I buy, etc. Here goes:

I am looking to buy a property in the 100-130K range, and I live in the SF Bay Area. Looking at a SFR in the not so nice parts of town. For the sake of calcs, lets say that a 100K home is going to rent for $1100.

My 100k came from a cash out when I recently refinanced my home. The refi loan is 300K, 3.5% @ 30 years. So plausibly, this 100K is costing me $450 of my $1350 monthly mortgage payment. I have another 30K saved to add to the investment cost or rehab.

For that 100K home that will bring in 1100/mo in rent, how do I go about figuring the return, and whether my 130K will be better invested elsewhere. I'm SURE that any 100K house around here will appreciate to 200K within this decade. These homes were selling for 400K in 2006.

Perhaps more plausible is that the SFR will cost all of my 130K, and will bring in 1200/mo.

HELP!! Thanks in advance for any assistance here.

J Scott · Answer

Just a quick follow-up to Frank Gallinelli's post... Here is an Internal Rate of Return (IRR) primer I put together a couple years ago on the BP Blog: http://www.biggerpockets.com/renewsblog/2010/09/02/introduction-to-internal-rate-of-return-irr/

Frank Gallinelli · Answer

Let me expand on @Jeremy Cyrier 's very good advice (and I am SO glad that someone is saying cash-on-cash return is inadequate because it fails to take time value of money into account) In simplest terms, you need to project your cash flows over a reasonable holding period, and then perform an internal rate of return calc. To estimate your year one cash flow, start with the gross rent and subtract an allowance for potential vacancy and credit loss (at least 3% but probably more since one lost month's rent in a SFR is 8%). Then subtract your expected operating expenses, such as property taxes, insurance, maintenance, leasing costs, legal costs, and any utilities or other expenses (e.g., water/sewer) that you may not be able to pass on to the tenant. Resisit the tempation to underestimate expenses. That will give you your Net Operating Income. In a conventional income property you would apply a cap rate to estimate value, but that is unlikely to be helpful with a single-family, so move on to cash flow. Next subtract your annual debt service and any capital costs (improvements) to get your first-year cash flow. Then project the potential growth in revenue and expenses forward for each of the next several years to get your estimated future cash flows. For the final year, estimate the resale price, and subtract the mortgage balance as well as your costs of sale (lawyer, broker) to get the cash from resale. Add these proceeds to make them part of your final year cash flow. Then do an IRR calculation on all the cash flows. Don't forget to include your closing costs to buy the property as part of your beginning-of-year-one cash outflow. If IRR is not well into double digits, then consider looking at alternative properties.

Ellis San Jose · Answer

You are getting some great guidance in this post. IRR is a good calculation to run. But be careful about projecting appreciation too optimistically on resale. It can cloud your decision making. Put more weight on current cash flow not resale 50% expense ratio is good rule of thumb Don't forget depreciation on your after tax income.

Jeff S. · Answer

Good luck, keep us posted.

Kamal F. · Answer

Ok, yes, I totally get that. Luckily I'm a handyman and I will be living close to whatever property that I buy. Although I would likely not rebuild the roof myself, any other repair can be done by myself for extremely cheap, so I am looking forward to the opportunity for sweat equity.

Jeff S. · Answer

Kamal F. you might be able to figure stuff for one year and get lucky but you are leaving a lot of potential expenses off. Here is an actual rental. There is cleaning and maintenance, there are repairs and there are larger expenses that you accumulate over time. If your roof last 20 years and it cost 10k to replace then you have used $500 each year. All in all the expenses can be estimated to be around 50%. You can subtract capital expenses and figure those separate but it is an expense either used now or to be reserved for future repacement. http://www.biggerpockets.com/files/user/Jeff1/file/sf-rental-income-and-expense-20-years

Kamal F. · Answer

Thanks for the reply. What does your last sentence mean?

Jeff S. · Answer

You can calculate depreciation into your tax analysis too. Principal pay-down is profit because returns are generally figured before debt relief. You may use profit to pay down debt or you could use interest only financing and put it in your pocket. Cash on cash is what you have left after expenses and debt payments. As you can see there are multiple ways to figure return. Someone should jump in here. Need to get to the post office to mail rent increase and notice to vacate.

Kamal F. · Answer

Thank you all for the replies. I came up with a sample calculation for a year of no vacancy, just to start understanding. I know it can get much more complex than this. Curious to know if I totally screwed anything up in this basic calculation. Purchase plus rehab = 125K Rent 15600 (1300/mo) Tax 1350 Insurance 800 Mortgage 5400 (450/mo for most of purchase price) Repairs 600 (I'm a handyman and will be servicing the property) Utils 480 Gross Profit 6970/125K = 5.5% Taxes paid Rent Income 15600 Deductibles Tax 1350 Insurance 800 Mortgage Interest 3636 (1764 principle) Repairs 600 Utils 480 Taxable Rent 8734 .25% tax rate 2184 tax Gross profit 6970 Net profit 4786 (399/mo) = 3.8% I am also wondering if the principle portion of the 450 mortgage payment is considered profit, which would change the net profit calc to this: Plus Principle (1764) 6550 (546/mo) = 5.2% Thank you in advance. In terms of the question about appreciation, then its pretty much a sure bet that after huge corrections some years ago, property is on an upswing in the San Francisco area.

Jeff S. · Answer

Kamal Freiha all the above examples are good stuff but what is helpful IMO is a down and dirty quick look at a property. If it doesn't pass this first test then you want to consider other alternatives. While it sounds like you are investing for appreciation, most people remember others getting burnt using that as a reason to invest. If you simply assume 50% for expenses and capital improvements (remember I said down and dirty) you have your $1100 rent netting $550 from your investment. 550x12mo=6600/100,000=6.6%. Your rate of return as if you paid cash would be 6.6%. If you use leverage paying 3.25 for money then you have a margin between your return and your cost of money. Next step is to analyze the condition of the property. Once that is done you can go into deeper analysis if you so choose IMO.