Finding Your Bottom Line

There are many ways of measuring the success of an investment, and the method you choose will largely be influenced by your definition of what success looks like and your tolerance for risk. As we touched upon in our previous discussion, when comparing rates of return of different properties based on their cash flow, we use metrics like Gross Rent Multiplier and Capitalization Rate.

That said, to get to the actual bottom line on how the property performs, we need to compare the cash flow and proceeds to the amount of actual money that was used to purchase the property. As a final step it is always wise to consult a CPA or other qualified tax advisor to get the full picture of the after-tax financial impacts, but an informed investor and their agent can measure a property’s pre-tax Internal Rate of Return over the life of the investment.

This is where leverage comes into play. Using the example of a $1,000,000 property with Annual Rents of $100,000 and Operating Expenses of 35% indicates that the property has a Gross Rent Multiplier of 10 and a Net Operating Income of $65,000, yielding a 6.5% Cap Rate. However, unless you paid all cash for the property, your cash flow-based rate of return will be based on what’s left after you make your monthly loan payment plus whatever you paid for Capital Improvements.

For instance, if you were to put 50% down and get a 30-year loan at a 6 % interest rate, you would pay $29,833 in interest over the course of the first year, which takes the Net Annual Income down from $65,000 to $35,167. And if we compare that cash flow to the $500,000 down payment, the cash flow-based return improves to around 7%. 

When you factor in the length of time you hold the investment, this is where the Internal Rate of Return is arrived at. In the case of the $1,000,000 property purchase above, if the investor used the same $500,000 to put down $300,000 and add $200,000 of Capital Improvements, their loan amount would jump to $700,000, which would put the cash flow-based return at 4.6%. On the other hand, when doing major renovations, you need to account for temporary vacancies during construction, so you may end up factoring in a break-even or even negative cash flow in arriving at your final projected return.

That said, if the investment brought the value of the building up to $1,350,000 and it sold in a year with a break-even cash flow, after taking off 6% for costs of selling would indicate a profit of $69,000. When compared to the $500,000 invested, this would indicate an Internal Rate of Return of 13.8%. Now consider if you were able to sell the property in 9 months that your Annualized Internal Rate of Return would jump to 18.4%. 

This kind of math is the strategic basis used by speculative investors and flippers, but anyone using a strategy like this should consider their fallback plan if the project takes longer, costs more, or sells for less than anticipated. And how you weigh the opportunities and the risks will ultimately help guide your chosen style of investment.