Real-estate investors benefit from their investment with cash-flow and with the build-up in equity. However, it seems people look at cash-on-cash return but ignore equity build-up. This seems logical if you look at a few years, but after >= 10 years, it seems wrong to ignore the effect of appreciation.
Some areas exhibit more growth then others, so it seems there should be a more complete metric.
A real-estate investment professional has showed me (among other things) the metric which was named "Cash on cash with equity build-up". It is calculated in a similar way to plain CoC:
CoC w/ Equity = (Net cash-flow + Equity increase) / Initial investment
Where Equity increase is the only new term which is: (i) the increase in property value (est.) (ii) the reduction in loan balance.
This can be estimated for a few years ahead to show a trend. Of course, term (i) is a guess, but could be done conservatively.
Q1: Is this metric usable? If not, what do you use instead?
Q2: Can I compare this metric to an interest rate I get from an alternative investment?
As an investor without large amounts of capital, you stand to lose loads of money if you try and add apples (actual, known, real numbers) to oranges (best guess numbers). When I look at properties, I like to add in some appreciation, just to see what that does to my numbers, but that's just making my dream spreadsheet and not what I use to decide if it's a good deal.
I'm not there yet, but it seems the bigger guys want to make sure there is enough cash flow to meet their requirements, but they rely heavily on appreciation to create the wealth they are after. Maybe it's a SFR vs commercial mentality? Hopefully someone in that space can shine some more light on it.
I don't use equity build-up in any formula, other than trying to find properties that should be worth more than my Offer from day one (forced equity), and any future appreciation becomes a bonus that can be acted on at a moments notice - in the future!
The reason being, properties can also FALL in value, but so long as the cash-on-cash returns are still in place - so what?...
@Ron Vered , Equity build-up is valid to look at if you want to compare owning real estate vs. other investments. However, I think you need to be careful about not confusing it with appreciation. You wrote:
"However, it seems people look at cash-on-cash return but ignore equity build-up. This seems logical if you look at a few years, but after >= 10 years, it seems wrong to ignore the effect of appreciation."
Appreciation is different - that is what occurs when a $150K house rises to $160K. When we speak about equity build, that refers to factoring in your 120K debt shrinking as you own the home (thus there is real "cash" you are "earning" if you hold long enough).
Equity build is important - aside from tax benefit and appreciation, it's why you investing in a corporate bond at 4% is less appealing than in a home that yields 4% after debt service. You're also having that debt paid down, whereas in the bond you only have a return of capital.
I haven't found a great way of factoring tin equity build. However, for my calculations I look to see if the annual cash flow less 15 year mortgage payments break even as an initial test (as I am not looking for income right now). This tells me I'll get fairly quick equity build without anything out of pocket (someone else is taking my $120K loan for me an paying it down). Call this EAP (Earnings after Payments)
To dig a little deeper, I'll also subtract the cash I tied up ($150K is about $30K + any rehab or closing costs at time of purchase) and apply a "cost of cash" (what is my opportunity cost of that investment in a fairly safe instrument), along with any EAP (can be positive or negative) and an estimate for my annual equity build (by estimating this from an amortization table).
Annual Benefit = Annual Equity Build + / - EAP - Cost of Cash
Note: This is not accurate / scientific / mathematically rigorous, and I'm not recommending it as a way to calculate returns. Once I have determined if something meets my CAP rate goals, I simply use this as interesting information for review as I compare it to other investments - but again, realizing it is false precision.
The metric you are looking for is IRR (Internal Rate of Return). It requires you to model through the exit of each asset, which is a best practice, in my opinion, to be able to properly benchmark investment opportunities and allocate personal capital. See below for an article on it.
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