WHAT RETURNS ARE YOU LOOKING FOR ? (Part 1/4)

I’ve been asked that question so many times by agents, brokers, investors, friends and family.

Return is a fundamental concept in real estate investing and it’s in the heart of what we do. So without further ado let’s start exploring the meaning of returns.

How do you know if you are getting a good return on your real estate investment? There are different types of return in the world of real estate; Cash on Cash Return, Capitalization (CAP) Rate, Internal Rate of Return (IRR), Return on Equity, Return on Investment (ROI), Yield and other financial measures that are less frequently used.

We often buy properties that are either non performing or under performing. We are not concerned with actual returns on date of purchase. We buy real estate based on projected returns when the assets are fully renovated, stable and 100% tenanted. When there is no positive operating cash flow or when a piece of real estate is sold at a loss returns would be either negative or wouldn’t make mathematical sense. For example, when purchasing a vacant apartment building that requires significant renovation it is understood that during renovation the property would generate an operating loss and therefore negative returns. However, once the building is fully renovated and tenanted it is likely to generate positive returns. So, actual returns are measured once we have executed our business plan and the property is completely stable and cash flowing.

Other types of returns, as we will see later, require selling or refinancing the property in order to realize returns that are not cash flow related.

One of the most important financial measures in real estate investing is the CAP rate short for Capitalization rate.

A Cap rate measures the rate of return on a real estate investment property based on the net operating income (NOI) the property generates and is expressed as a percentage. The Cap rate can be calculated by dividing the NOI by the market value (or the total cost basis) of the property.

We use a conservative approach in underwriting investment opportunities and determining an accurate, real-world NOI. Gross annual rent is adjusted for vacancy and credit loss based on location and asset class. All operating expenses are subtracted from the net annual rent (read out post about real world projections). The figure we get is the annual operating income or NOI.

When dividing the NOI by the market value of the property we get the Cap rate. The market value can be the price we are willing to pay for a real estate transaction or the market price of a property we already own. We use the Total Cost Basis to compute Cap rates.

When we underwrite a real estate transaction we would project the gross annual rent roll, the vacancy and income loss, and all operating expenses. We would estimate the acquisition price, closing costs, development (hard) costs, finance and soft costs to derive at the Total Cost of the project. By dividing the projected NOI by the projected total cost we would get the Cap rate.

Please remember a projected Cap rate is only as good as the the underwriting assumptions used to compute your model.

To be continued in the next post