Investment Blog – March 2018
For my blog in March, I wanted to cover common ratios used to evaluate investment properties. After my last post, I had several questions, so I thought I would break these down.
First, it is worth covering the four benefits to owning real estate.
The first is the most obvious, cash. People pay you cash above and beyond your expenses (hopefully!) to live in the property you own.
The second is principal reduction. Many investors tend toward a more highly leveraged strategy. Say an investor has $100,000 to invest, they would prefer to invest in five $100,000 homes putting 20% down, rather than paying cash for one home. Because of this loan, the investor’s payment includes a principal payment and an interest payment. This paying down of principal is an expense in the cash benefit above, but is still a net positive benefit over the course of the year.
The third benefit is tax savings. Depreciation, loan interest, and operating expenses can all be written off on an investors taxes, creating a reduction in overall taxable income, and a tax savings.
Finally, real property appreciates. It grows in value, creating a net benefit.
Now that we understand the four benefits to owning real estate, now we can analyze a property’s return using ratios. Ratios help take properties that differ in nature or price, and give us an apples to apples comparison.
ROI (Return On Investment): This ratio measures the total return and compares it to the cash investment. It measures how much total benefit an investor receives in relation to how much cash they had to use to realize that benefit. You will notice, I do not include appreciation on one of my ratios. It is my belief that if you have to bank on appreciation to make an investment work, it is not a good investment.
Capitalization Rate: Cap rate is your net operating income (which would be profit if an investor had no mortgage) divided by the capital investment. It is basically a measure of how quickly an investment pays itself off, and simplifies the analysis by removing lending from the equation. For example, if someone found a lender that was willing to give a 100% loan based on other assets a investor had, then their cash-on-cash would be infinite, or thousands of percent. While other statistics can be skewed, the cap rate tends to give a clear and simple percentage that can be compared to any other cap rate accurately.
Cash-on-Cash: This is a ratio that many short term investors look at. This ratio measures how quickly will your cash replenish itself. It is straight forward, and can be useful in certain contexts.
I hope this information helps. If you would ever like to discuss investing in the area, please don’t hesitate to call us here at Foundation Realty!