I am always approached by investors looking for a “good deal”. But what might be a good deal to you is not necessarily a good deal to another. You have to determine your short-term and long-term goals before seeking a particular investment. When you do decide upon your goals, there are many ways to determine the return on investment or ROI when comparing properties but which one is the best?
Let’s take a look at the different methods of factoring yield on income producing property. Yes, we are only talking real estate here as that is my expertise.
There are many factors that contribute to yield or value and you should consider how many of these factors are utilized in the approach that you take in comparing investment opportunities. The factors are:
Location, size, income, appreciation, expenses, price, leverage, financing terms, principle reduction, tax benefits, tax bracket of investor, rental increases/decreases, additional tax incentives, reinvestment of cash flow, closing costs, Capital Gains tax, risk and timing.
The different approaches to determine RIO are as follows:
PPSQ: Price per sq. ft/ unit: This method divides the price of the property by the sq. ft. or number of units only. This method is really only useful when comparing apples with apples in a market that you or your agent are very familiar with prevailing prices. Amenities, upgrades, use-able space, income, expenses, location, leverage and other factors are not considered here so other methods should be utilizeded in addition to this approach.
GRM – Gross Rent Multiplier: You arrive at this method by dividing the price of the property by the current annual gross scheduled income (units x rents). Again, factors not considered are: rental increases/decreases, expenses, leverage, etc. and you should delve deeper into the investigation by following up with other methods.
CAP Rate – Capitalization Rate: The Net Operating Income (NOI) divided by the price. This method is by far one of the most utilized but does it provide a true picture of the investment? Factors not considered that should be: Tax advantages, leverage, appreciation, costs of sale, reinvestment of cash flow, etc. Yes, this does provide a quick one-year only snap shot but leaves a lot to conjecture and should be supplemented by additional approaches.
COC – Cash on Cash: The first year’s pre-tax cash flow is divided by the initial invested dollar – contract down payment plus any hard closing costs. This method delves deeper into the actual return, but again does not take into account: risk, tax benefits or tax bracket of the individual investor, costs of sale, reinvestment of cash flow, appreciation, etc. This is basically a “one year” snap shot of the property , making no assumptions other than that the income, expenses and debt service (leverage costs) will remain as they are today for at least a 12 month period.
ERR – Equity Rate of Return: This is the sum of the first year’s pre-tax cash flow, first year’s tax benefits from all sources, first year’s principle reduction and an assumed first year’s appreciation – all of which are then divided by the initial invested dollar. While this method does take into account the highest number of all measurements of return, this is only for one year, and you cannot get appreciation without considering Cap Gains and closing costs nor can you benefit from the principle reduction with selling.
IRR – Internal Rate of Return: This is the rate of discount at which the present value of the future cash flow is exactly equal to the initial capital investment. This is a multi-year analysis complete with assumptions into the future regarding rent increases, expenses and assumed appreciation of the property. One must remember that your computations are only as accurate as your assumptions, which should be based on conservative figures backed by credible historical data. This method does take into consideration a majority of the factors with the exclusion of risk and reinvestment of cash flow. The downfall of using the IRR approach is the assumption of your ability to reinvest the annual cash flows at the IRR, which may or may not be possible. IRR does not take into account actual reinvestment rates available in the market place. Also, if there is going to be negative cash flow, this money will have to come from somewhere and most likely it will be the investor.
FMRR or MIRR – Financial Management Rate of Return or Modified Internal Rate of Return: This approach is thew rate of discount at which the present value of future cash flows is exactly equal to the initial investment, assuming reinvesting interim year cash flow at realistic and reasonable attainable rates. This is a multi-year approach complete with assumptions into the future regarding rental increases, expenses, appreciation of property and reinvestment rates for interim cash flow. This is considered to be a very thorough approach to income analysis but does not consider risk – a factor in all real estate investments.
To sum up, when looking for income producing property, make sure you are utilizing every tool in your toolbox. Did I mention that Houston, TX has been named one of the best places in the US to invest?