We’ve almost waded through the whole gamut of real estate terms. I hope these terms, perhaps confusing at one time, are much clearer now. As complex and disconnected as they all sound, the various terms and calculations come together in perfect harmony to show you the best deal. You should consider these calculations mandatory to your success as a real estate investor. Sure, some folks make money on real estate without spreadsheets and other calculation tools, but they do that in spite of running the numbers. Some of the seasoned experts can go off of gut feel, but if you are new or a little wet behind the ears, trust in these calculations and let cold hard facts be your guiding light.
Return on Investment (ROI)
If you want to flip your property or see how you did after selling a property, Return on Investment (ROI) is the foundation behind it all, and another good calculation to throw in your tool box. ROI is essentially the amount of money you get back from your total real estate investment. When you put money in, you expect to receive that same money back and a little more besides. If you flip the property, you’ll want to sell the property for more than you paid for it, minus expenses.
How is this different from Cash on Cash Return (CCR) or Cap Rate? Simply put, CCR and Cap Rate are both types of ROI. ROI is your return on the entire amount invested into the property, typically after sale, while CCR is the amount of cash you get back for your own cash invested. The Cap Rate is your yearly return if you paid cash for the property, without an increase/decrease in property value coming into play.
The real purpose of ROI is seeing what your average return is from your flip. Let’s go back to the familiar example we all know and love and throw a little appreciation in there!
Purchase the property:
$100,000 cash invested
$6,588 Net Operating Income (6.6%)
Let’s add 2% Appreciation for 5 Years to this:
$110,408 (new value of property)
$32,940 5 years of income
Total: $143,348 return on a $100,000 investment
Yearly ROI cash value: $43,348 / 5 = $8669.60
ROI: $8,669.60 / $100,000 = 8.67%
So, although you can see that the NOI was 6.6%, your total yearly ROI ended up being 8.6% after selling the property. This is mainly due to the appreciation you enjoyed, which won’t factor directly into your NOI, but will show up once you sell the property.
Remember, for the purposes of this example, that this ROI is before tax. We are not looking at depreciation, capital gains taxes, or potential real estate agent fees for the sale. If you hold the property longer than 1 year and 1 day, you can deal with the capital gains taxes by filing a 1031 Exchange and rolling your cash over to a new investment property tax-free.
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When you flip houses, this ROI will work very well for you, especially since you aren’t trying to get actual cash from the property via rent. For flipping, do similar calculations, but be sure to subtract rehab expenses after you buy your property so low. You also won’t be renting the property, so you won’t have any NOI to consider.
Purchase the property:
$60,000 purchase price
$60,000 cash invested
+ $30,000 rehab costs
= $90,000 cash invested
Flip the property after repair:
$100,000 new property value
$100,000 – $90,000
——————————– = 11.1% ROI
Not too shabby. We’re simplifying the calculations a bit so you can understand. The ROI is extremely important when flipping properties since you want to see how much you will make off the flip. For example, if your ROI is falling below 3%, you are almost better off putting your money in your 401k or buying bonds and treasuries. Make sure your risk pays off and that your investment will return more than other safe investments out there!
We hope you enjoyed our Investing Defined series, where we discussed a suite of investment terms and calculations such as Cash Flow, Cash on Cash Return (CCR), Net Operating Income (NOI), and Cap Rate!