Payback Ratio: Know When You Will Recapture Your Initial Investment

The Payback Ratio is just one of a variety of calculations investors might use when evaluating a real estate investment opportunity. And though it's not as popular as perhaps capitalization rate or internal rate of return for making investment decisions, that's not to say the payback ratio can't provide some benefit to real estate investors.

Namely, the ratio provides a good starting point for investment decisions because it answers the question: "How long will it take for me to recapture my initial cash investment from the property's anticipated future net cash flows?"

In other words, the investor can get an idea of how long it will take to collect enough cash flow from the property to offset the amount of cash it takes (e.g., the down payment and closing costs) to make the purchase.

Since Payback Ratio relies on data that is highly speculative (e.g., income and operating expenses), especially over a number of future years, it's not a measure investor's can rely upon to make an investment decision. But here's what it can do: It can help the investor determine which might be the better option when comparing several investment opportunities.

Formula

I ÷ C = R

where,
I = initial cash investment
C = net cash flow
R = payback ratio

Let's say you're buying a rental property that will require $300,000 down, generates an annual cash flow of $28,000, and you want to calculate how many years it will take to recapture your cash investment.

$300,000 ÷ $28,000 = 10.71 years

The following image is a screenshot taken from iCalculator that shows you the calculation and result from our example.

Bottom Line

Payback ratio provides little explicit criteria for decision-making. But, as suggested earlier, it may be useful initially to determine how long before the property pays for itself. So you might consider using it.

Here's to your real estate investing success.