Real estate investment is a vehicle that attracts many people; it can seem like a no-brainer investment. However, if you don’t understand how the property makes money, you might not make any.
When investing in real estate there are two ways to make money: appreciation over time and cash-on-cash returns. Since the crash of the housing market several years ago, there is no guarantee at this time that your real estate properties will be appreciating in the future. Most likely this will happen, but when making a real estate investment today it is important to act on what you do know.
Cash-on-cash returns are the best way to make money off of a real estate investment. Before you invested your money into real estate it was most likely earning you money in CDs, stocks or bonds, earning up to 7.5%. Since real estate investments are higher risk than these other routes, you will want to make sure your cash-on-cash return is worth the risk.
When making a real estate investment you will want to know exactly how much cash you are investing to properly calculate your returns. Some investors make the mistake of only totaling the amount of the mortgage. In reality you are investing a down payment and closing costs as well, which can be a total of 30% or more of your loan amount.
Calculating Cash Return
Here are the simple calculations that many investors easily overlook when deciding if an investment property is worth the risk:
Cash Equity = down payment, closing costs/loan fees, rehab costs
Monthly Rent – Operating Expenses = Net Operating Income
Net Operating Income – Your Mortgage Payment = Monthly Cash Flow
(Monthly Cash Flow x 12 months) / Cash Equity = Return on Cash
When preparing to do these calculations it is vital that you use accurate numbers. Do not guess if at all possible. If you need to use estimated numbers, always round up on expenses. If your operating expenses end up being less it will only be added profit for you.
Just to make it a little easier to picture, here is an example:
You obtain a $300,000 mortgage and make a 25% down payment of $75,000. Your closing costs are $30,000 (they are typically around 10% of your loan amount). You invested $10,000 into the house to prepare it for renters.
Cash Equity = $75,000+$30,000+10,000
Cash Equity = $115,000
You are able to rent the house for $2,200 per month with operating expenses of 30% (or $660).
Net Operating Income = $2,200 – 660
Net Operating Income = $1,600
Monthly Cash Flow = $1,600 – $983 (mortgage payment)
Monthly Cash Flow = $617
($617 x 12)/$115,000 = cash return
6.4% Cash Return
Find Where the Money Is
Many investors want to buy rental properties that are on the beach or with beautiful mountain views, places that are often thought of as “prized properties.” It can be upsetting to them to realize that these properties are usually not the ones that are going to provide them with a good cash-on-cash return. If you are looking to invest, find where the money is with proper calculations and let that determine where you buy.