Is control a benefit to real estate investing?
How do you know if you are receiving a good return on your real estate investment? Calculating the ROI is crucial to know how your investment is performing, or when comparing one investment to another.
Many people on BiggerPockets.com say that the control you have when investing in real estate is a big reason to choose it over investing in the stock market. You as an owner of a property can take steps to increase the value of that asset. Whether it’s through sweat equity or attracting great tenants, you are in control. When it comes to stocks, as the argument goes, you have no control. There is very little action you can take to change the price of Microsoft stock. This argument is precisely the wrong way to think about investing.
When you buy a stock, you become a part-owner of that business. The stock price is important but not as important as the quality of the underlying business whose economics will succeed over the long-term. A stock investor should try and determine what a business will look like in three to five years and buy it at a discount from their estimate of business value just like you would when purchasing a real estate investment property. Control by itself is not a benefit - it’s something you can brag about on blog sites or at parties, but shouldn’t be strongly considered when discussing ROI.
For me to take active control of an investment, I have to be almost certain that I can achieve a higher rate of return than the passive seven to nine percent I can get in index funds. So when I’m deciding whether a property is worth buying, I look at two specific types of returns: Cash-on-cash return on investment, and total return on investment. I’ll write about the total return on investment in another post but let’s dig into the first formula.
The cash-on-cash return of an investment property is equal to the annual cash flow (before taxes) divided by the amount of capital you initially invested. Your before-tax cash flow is calculated by subtracting your annual mortgage payment from your net operating income (NOI). The net operating income is simply the total income from the property minus the total expenses.https://www.wallstreetmojo.com/cash-on-cash-return/
It’s important to understand the two parts of this equation because this can be an incredible benefit to real estate investing:
- The first-year cash flow (or annual cash flow) is the amount of money we expect the property to generate during its first year of operation. Again, this is usually cash flow before tax.
- The initial investment is generally the down payment. This includes closing costs such as loan points, escrow and title fees, appraisal, and inspection costs.
What the cash-on-cash return is pointing to, indirectly, is leverage. In other words, how much money did you have to spend to gain the entire benefit of the asset?
This is one of the advantages real estate has over the stock market - you don’t have to pay for 100 percent of the asset to get 100 percent of the benefit! If you want the benefit of owning a share of Amazon, you have to wait until you have $1,600 or so to buy a share. If you want the benefit of owning an investment property, you don’t have to wait until you have the asking price in cash. You can use leverage.
I am constantly analyzing both parts of this equation - how can I improve the cash flow immediately after I take ownership? Or how can I take ownership with less of my money?
To improve the cash flow, look at the property and try to find places for improvement. Some examples are:
- Current owner is paying for all the utilities
- There is a higher than the market average turnover rate
- The current owner is paying for a grounds management company
- Current rent is below market average
Doing this takes time and patience, but again, if you really want to take control of an asset you better make sure your ownership will dramatically improve your returns.
The second way to improve cash-on-cash return is by reducing the amount of personal cash you use to buy the property. The typical way people do this is by increasing their leverage (i.e. taking on more debt). This can work but many people rely on high levels of appreciation to justify their equity position.
I look for ways to reduce the amount of personal cash I put into a property by getting creative. For example, I am currently looking for a duplex that needs significant renovations. I would partner with a hard money lender to finance approximately 70 percent of after renovation value (ARV) of the property, fill both units with renters, and refinance within six to nine months to pay back the hard money lender, thus leaving me with 30 percent equity in the deal. Now if I can find a property where the purchase price and renovation costs equal 70 percent of the ARV, I will be able to buy an asset with zero of my own money, thus having an incredible cash-on-cash return.
There are some weaknesses to this formula, which is exactly why I don’t rely on it alone when analyzing an opportunity. It doesn’t factor in the time value of money, which is why you should really only use it for the first year of ownership, and it is based on simple interest and not on compound interest calculations. An investment opportunity with an even small rate of compound interest may be a superior opportunity than an investment with high cash to cash return.
Some of my clients have a base level for what sort of cash-on-cash return an investment opportunity must get to even consider taking control, others use the formula more as an indicator that creativity is required to increase the benefits of a particular investment property. Either way, this is only one type of return I really consider for investments. More to come on that, but in the meantime, let me know how you use the cash-on-cash formula with your investments.