How do you calculate investment property returns?
Investment properties are great investment vehicles, but they can be difficult to evaluate. Cap rates (operating income/purchase price) are typically used to compare investment property investment options. But cap rates don’t factor in mortgage cost, and don’t tell an investor their annual return on investment.
An investor is considering real estate vs. something paying 10-15% per year, they need a way to compare. Everyone understands the simple concept of cash-on-cash. It is as straightforward as it implies, and offers a way to compare different types of income.
Real estate investors will want to calculate exactly how much out-of-pocket cash they have put in the business. Then they need to understand net operating income (revenue minus expenses). In addition, the a real estate investor must assume a sale of the property at some future date. An annual rate of property appreciation, up through the sale date, must be factored into the sale price.
IRR (internal rate of return) is a return rate that can be calculated and compared to other investment options. The real definition of IRR is the discount rate that makes the net present value of all future cash flows equal to zero. It can be used to compare different types of investments on the same basis. In general, the investment that generates the highest IRR is best.
The attached investment property calculator lets one enter certain mortgage, operating cost, appreciation rate and sale date assumptions to get an estimated IRR.
