Dissecting Real Estate Returns: How to Actually Know What You Are Making on Your Investment
One of the most common questions when getting into real estate investing is what kind of returns can you expect. Although there is no fixed answer for this, there are some important things that you have to know in order to answer the question for yourself.
This article will talk about the different types of returns you can earn by investing in apartments so you’ll be able to better assess what real estate can really do for you.
A General Note on Real Estate Returns
One of the greatest things about real estate investing is that it provides investors with passive income. This means that you receive ongoing cash flow as it operates each month. Depreciation of the asset allows you to offset the passive income earnings, meaning you keep more of it and lose less to taxes than the salary earned from your active income (i.e. your day job). On top of that, you can make even greater returns when the asset is sold in the future.
As inflation rises property value tends to follow. And if your investment team is properly managing the asset, it’s income will also rise as well, meaning real estate can be the perfect hedge against inflation. With this in mind, we can confidently say real estate is one of the best, if not the best investment on the planet.
Still, each person has to decide what their risk tolerance is, what returns they need to achieve financial goals and understand their overall financial situation before getting into real estate. Besides, every deal is unique and there are many factors that may affect the returns on any given property.
Having said that, let’s delve into the three types of returns you can expect from real estate.
Cash on Cash (CoC) Returns
This measure is used to calculate the cash income earned on the cash invested in a property. This is done by measuring “the annual return the investor made on the property in relation to the amount of mortgage paid during the same year” (in Investopedia’s terms).
This rate is calculated typically on a yearly basis, and is used to determine the overall return on investment (ROI) of a property.
For example, if you invest $100,000 into a multifamily deal and you earned $8,000 that year from cash flow, you divide the initial investment by your cash flow distribution:
8,000/100,000 = 8% CoC return
Cash on cash is the most popular metric to assess the performance of a real estate investment as it accounts for the actual cash returns from the monthly operating income of the property plus the sum you’ll receive when it’s eventually sold.
So, what is a good Cash on Cash Return?
While experts disagree, and it also varies from one property to another, many passive investors look for returns in the 8-10% range.
Finally, CoC is not the end-all, be-all of real estate returns, as it does not consider tax benefits or the value appreciation of the investment. Multifamily assets can take advantage of forced-appreciation, meaning the value of the property increases as the income it generates increases. More on this in our article on appreciation vs depreciation.
Internal Rate of Return (IRR)
The internal rate of return is, in general terms, a calculation to estimate how profitable an investment can be over the entire course of ownership. It measures a property’s long-term yield (that is, the total return the investment provides).
As you know, balancing risk and reward is key to achieving substantial returns that are still sustainable. The IRR can help you measure that in practical terms. With it, you can calculate the return on your investment during an entire holding period.
Calculating IRR can be complex as it takes into account many factors. Depreciation, dividends received over the span of ownership, all future anticipated cash flow, debt payments and refinance are all taken into account to calculate this rate. But don’t worry, a good real estate investment team will help you calculate this rate based on the amount you’re investing in the project.
To summarize, the internal rate of return is a formula to calculate the returns on investment over time. This can help investors decide whether this property gives them an edge over other ones, and it is a crucial information for making accurate investment decisions.
Annual Average Return
When people ask “is investing in real estate better than stocks?”, this is the data they should be looking at. And just to answer that one: it depends. A good real estate investment can beat the S&P 500, but there is no clear way to know if you never look at the numbers.
This is where the average return comes in. Considered annually, this rate will tell you the overall return on investment your investment is providing.
In order to calculate it, you need to take into account the cash flows and selling profits, divided by the invested amount and then divided by the number of years of the investment. That way, you can have a percentage number like 8% that will quickly let you decide whether your investment is performing as expected or not.
Here’s an Example
Quick disclaimer: this is a hypothetical example, the returns on every project are different. This is in no way intended to be financial advice, it’s merely for illustrative purposes.
PROJECTED RETURNS
Preferred Rate of Return 8.5%
Total Investor IRR 12%
Annual Average Return (AAR) 12.5%
Investment Term 2-6 years
The Bottom Line Is This: You Cannot Make Decisions Without Accurate Numbers
Passive real estate investment is all about knowing your numbers. You don’t decide by your intuition or neighborhood gossip. You take a hard look at the numbers, and make informed decisions that really allow you to build wealth.
If managed properly, real estate can give you annual positive yields without the volatility of the stock market or wasting months looking for opportunity. All of this with passive cash flow and big paydays from cash-out refinancing or selling the property. It can give you financial security and freedom, and allow you to build generational wealth that is based on a physical asset that will always hold value.
But how can you do it without devoting years of your life to learn about real estate? Let our trusted experts guide you through the ins and outs of creating true wealth with real estate investing. Make the smart decision, make Titanium Investments your partner.
If you’d like to talk with one of our in-house staff to guide you around the sometimes- complicated, but doesn’t have to be, world of real estate, contact us here. We’ll wait for you.