Financial Answer Center
- Introduction
- Financing Your Investment
- So You Want to Be a Landlord?
- Is Professional Management Right for You?
- Buying the Right Type of Property
- Finding the Right Property in the Right Location
- It's Number Crunching Time
- Uncle Sam: Your Partner in the Deal
- Other Real Estate Investments
- Converting Your Principal Residence
- Some Helpful Hints
Once you've found one or more properties that meet your objectives, it is time to crunch the numbers. This analysis may seem complicated (because it is), but it is essential that you calculate the return on your investment. After all, if you aren't going to make any money, then it is pointless to buy the property.
Running the Numbers Examples
Cash Flow
This analysis illustrates how much spendable cash an example property will generate for the year. It is the same concept as doing a cash flow statement for yourself, except you are now focusing on a piece of your portfolio instead of your entire financial situation.
Rate of Return
There are several different rates of return that you can look at once the cash flow analysis is complete. The rates of return tell you how you can expect the investment to perform.
First let's look at the return on the investment, both before and after income taxes. It is calculated as follows:
|
Before-Tax Return on Investment |
|
|
Cash flow before taxes |
$6,100 |
|
Investment (down payment) |
55,500 |
|
= Before-tax return on investment |
11.0% |
|
After-Tax Return on Investment |
|
|
Cash flow after taxes |
$5,150 |
|
Investment (down payment) |
55,500 |
|
= After-tax return on investment |
9.28% |
Return on Equity
It is also a good idea to look at the return on your equity, which provides you with a more valid measure of your investment's performance. Equity represents your stake in the property; the amount of cash you would walk away with upon sale of the investment.
|
(1) Cash flow before taxes |
$6,100 |
|
(2) Property value at year end |
$210,000 |
|
(3) Loan balance |
$140,000 |
|
(4) Equity (2−3) |
$70,000 |
|
(5) Return on equity (1÷4) |
8.7% |
Compare the results to the rates of return of your other investments and evaluate if the risk and the work associated with owning the investment property is worth it.
Internal Rate of Return
Most smaller-scale investors find the above return analysis ample to evaluate the investment. If you want to figure a more sophisticated and precise rate of return, you can come up with the internal rate of return or IRR. In order to do so, you need to understand the principles of time value of money.
In a nutshell, the IRR tells you the percentage rate of return it takes to make your initial cash investment equal to the present value of all the benefits associated with the property, taking into account the time value of all costs and income received.
IMPORTANT NOTE: Because further explanations and calculations are complex and beyond the scope of this Guide, you should consult an accountant for help in computing the IRR. Keep in mind that this calculation is generally only necessary for large-scale sophisticated investors in multi-family and apartment/commercial properties.
