If you buy a house and plan on keeping it for the long term, then you are an investor. It doesn’t matter if you plan on having just one house or an empire of 7 + houses like me, you are still interested in your rate of return.
While the key to being a successful investor is remembering that this is a marathon not a sprint, knowing my return on an investment makes those more difficult moments a bit more tolerable.
Learn How to Calculate a Rate of Return for a Rental Property
There are two general ways investors calculate their rate of return when it comes to their investment.
The first is their cash-on-cash return and the second is the CAP rate.
For the sake of the discussion, below are the numbers we will use for the examples.
Example 1
Purchase Price – $100,000
Down Payment Percent – 5% down
Down Payment Amount – $5,000
Cash Flow – $300 monthly/ $3,600 yearly
Example 2
Purchase Price – $100,000
Down Payment Percent – 20% down
Down Payment Amount – $20,000
Cash Flow – $300 monthly/$3,600 yearly
What Is a Cash-On-Cash Return?
Cash-on-Cash Return – This method evaluates your return based on how much down payment cash you have put down on the house.
Equation- Cash Flow/ Down Payment
Example 1
$3,600/$5,000 = 72%
Your cash-on-cash return by evaluating your cash flow is 72%, not including expenses (maintenance, property management fees, etc.)
Example 2
$3,600/$20,000= 18%
As you can see the higher the down payment, the lower the cash flow. Our houses that we buy as personal properties do much better than the houses that we buy as pure rentals because they require 5x more down.
The benefit to this method is the fact that you can take into account the down payment amount. As an investor there is the opportunity cost of future investment. There is a limited amount of cash, so the more I have to put in one house the less I have for the next.
The negative to this equation is that you really need to know the down payment amount, so the numbers are hard to compare to other investments.
How I Use It
I use this calculation when I am figuring out what I am making on my houses. I compare this number to the markets, etc. This is the number that helps me get through those moments, (yes, landlording has LOTS of moments) and reminds me why I am in this marathon.
What Are CAP Rates?
Capitalization (CAP) Rates – This evaluates your returns based on if you are paying cash; not on your down payment amount.
Basic Formula – Cash Flow/Cash Price
$3,600/$100,000 = 3.6%
As you can see the CAP rate is much lower than the cash-on-cash rate. The benefit to this is it’s easier to compare one asset to another as long as the purchase price is the same.
How I Use It
I personally only use it for the apples-to-apples comparison. The whole point for me of buying houses is being able to use the leverage. I strive for 0% down, and while not always possible, I like to put as little down as possible. The whole point of this for me is the leverage.
My favorite method is cash-on-cash. For me, the idea behind my houses is to leverage as much as possible while having the tenants pay off the houses. The hope is that my sweat equity of managing the houses will pay off the houses, not having my money pay it off.
That’s how to calculate a rate of return for your rental property — using either a cash-on-cash return or a CAP rate.
What method do you prefer?
The post How to Calculate a Rental’s Rate of Return appeared first on The Reluctant Landlord.