1.Gross Yield
The gross yield is a key metric used in property investment to determine the potential return on a property. It is calculated as a percentage and represents the relationship between the income generated by a property and its value. Here’s the formula and an example of how to calculate gross yield:
Formula for Gross Yield:
Gross Yield = (Annual Rental Income / Property Value) x 100
Example:
Let’s say you have a property with an annual rental income of $30,000 and a property value of $500,000. Using the formula:
Gross Yield = ($30,000 / $500,000) x 100
Gross Yield = 0.06 x 100
Gross Yield = 6%
In this example, the gross yield for the property is 6%. This means that for every dollar invested in the property, you can expect to receive a return of 6 cents in rental income annually.
The gross yield calculation is useful for property investors as it provides a quick and simple way to compare the potential return of different properties. It helps investors to assess the income-generating potential of a property relative to its cost, allowing for quick comparisons between properties of different values and rental income. Additionally, the gross yield can be a useful indicator of the overall performance of a property in relation to its market value.
However, it’s important to note that while gross yield provides a quick snapshot, it does not take into account the property’s operating expenses, financing costs, or potential for rental growth. Therefore, it’s essential to consider other factors such as net yield, capital growth potential, and overall investment strategy when making investment decisions.
2. Net Yield
Net yield, also known as net rental yield, is an important metric in property investment as it provides a more accurate measure of a property’s income-producing potential by factoring in expenses related to property ownership.
The net yield formula is:
Net Yield = ((Annual Rental Income – Annual Property Expenses) / Property Value) x 100
Let’s use an example with the following figures:
Annual rental income: $30,000
Annual property expenses (e.g., property management fees, repairs, insurance, property taxes): $5,000
Property value: $500,000
Net Yield = (($30,000 – $5,000) / $500,000) x 100
Net Yield = ($25,000 / $500,000) x 100
Net Yield = 0.05 x 100
Net Yield = 5%
In this example, the net yield for the property is calculated at 5%.
The net yield calculation is useful because it gives a more accurate indication of the property’s profitability, as it accounts for the operating expenses associated with its ownership. It helps investors understand the actual income they can expect to derive from the property after deducting these costs.
Difference between gross yield and net yield:
The main difference between gross yield and net yield lies in the inclusion of expenses. Gross yield only considers the rental income in relation to the property’s value, providing an indication of its income-generating potential without accounting for expenses. In contrast, net yield factors in the property’s operating expenses, providing a more realistic measure of the income the property is expected to generate based on these costs.
In summary, while gross yield gives a general view of the income potential, net yield presents a more precise representation of the property’s capacity to generate income by considering the actual return after deducting costs. Therefore, net yield is a critical metric for investors when assessing the financial performance and profitability of a property investment.
3.Cash on Cash Return – COC
The cash on cash return is a valuable metric used in real estate investment to evaluate the profitability of an investment property. It measures the annual return on the actual cash invested in the property, providing a simple yet effective way to assess its performance. The formula for calculating cash on cash return is as follows:
Cash on Cash Return = (Annual Pre-Tax Cash Flow / Total Cash Invested) x 100
Where:
Total Cash Invested = Down Payment + Closing Costs + Renovation Costs
Let’s consider an example to demonstrate the calculation of cash on cash return:
Suppose you have made a total cash investment of $100,000 in a rental property:
– Down payment: $80,000
– Closing costs: $10,000
– Renovation costs: $10,000
If the property generates an annual pre-tax cash flow of $12,000, we can calculate the cash on cash return as follows:
Cash on Cash Return = ($12,000 / $100,000) x 100
Cash on Cash Return = 0.12 x 100
Cash on Cash Return = 12%
In this example, the cash on cash return for the property is calculated at 12%.
The cash on cash return is a useful metric in real estate investment as it provides a straightforward measure of the annual return on the actual cash investment. It helps investors compare the returns from different investment opportunities and make informed decisions about where to allocate their capital. Additionally, the cash on cash return accounts for specific expenses and reflects the performance of the investment property based on the cash invested, making it a valuable metric for assessing investment viability.
4. Internal Rate of Return – IRR
The internal rate of return (IRR) is a method used to estimate the profitability of an investment. When applied to property investment, the IRR reflects the annualized rate of return that can be expected from a real estate investment over its holding period. The IRR is especially useful for evaluating the potential return on investment and comparing it to alternative investment opportunities. The IRR can be calculated using spreadsheets, financial calculators, or specialized software. It’s based on a series of predicted future cash flows over the expected holding period of the real estate investment.
Here is an example of how to calculate the internal rate of return for a property investment:
Let’s say you are considering a real estate investment that requires an initial investment of $200,000. Over a 10-year holding period, the investment is expected to generate the following annual net cash flows:
Year 1: $20,000
Year 2: $22,000
Year 3: $25,000
Year 4: $30,000
Year 5: $40,000
Year 6: $45,000
Year 7: $50,000
Year 8: $60,000
Year 9: $65,000
Year 10: $70,000
With these cash flow projections, the calculation of the IRR typically involves utilizing specialized software or financial calculators, or it can be achieved through trial and error methods.
Using a financial calculator or specialized software, the calculated IRR for the investment is determined to be approximately 12%. This means that the investment is expected to generate an annual return of 12% over its 10-year holding period.
Summary:
The IRR is a valuable metric for evaluating the potential return on investment in real estate. It provides a single rate that reflects the profitability and attractiveness of the investment opportunity. The IRR takes into account the timing and magnitude of future cash flows, providing a comprehensive assessment of the investment’s potential. A higher IRR indicates a more desirable investment opportunity, while a lower IRR may suggest a suboptimal investment. However, the IRR should be used in conjunction with other valuation methods and investment criteria to make well-informed investment decisions.
5. Property Analysis – ROI
To provide a comprehensive example of a property investment analysis for a residential property, I’ll illustrate the process of calculating rental income, expenses, and return on investment (ROI).
Example:
Consider a residential property with the following details:
– Total Property Value: $300,000
– Annual Rental Income: $26,400
– Property Expenses:
– Property Taxes: $2,500
– Insurance: $1,000
– Maintenance: $1,200
– Property Management Fee: $2,500
– Vacancy Loss: $1,200
Calculation of Net Operating Income (NOI):
Annual Rental Income: $26,400
Total Expenses: $8,400
Net Operating Income (NOI): $26,400 – $8,400 = $18,000
Calculation of Cash Flow:
NOI: $18,000
Mortgage Payments and Interest: $13,200
Cash Flow: $18,000 – $13,200 = $4,800
Calculation of Return on Investment (ROI):
Total Cash Invested: $60,000 (20% down payment, closing costs, and initial repairs)
ROI: ($4,800 / $60,000) x 100 = 8%
Summary:
The property investment analysis provides a detailed understanding of the income and expenses associated with owning a residential property. Calculating the Net Operating Income (NOI), cash flow, and Return on Investment (ROI) allows investors to assess the financial performance and potential return on their investment. A positive cash flow indicates that the property generates more income than it costs to own and maintain. A higher ROI indicates a better return on the cash invested, and, generally, an ROI of over 8-10% is considered a good return on investment for a residential property. However, the perceived “good” return may vary based on the investor’s risk tolerance, market conditions, and investment goals.
6. Net Operating Income – NOI
NOI tells you how much money you make from a given investment property. It’s a version of a high-level income statement. To calculate it, take your total income and subtract operating expenses. Never include your mortgage payments in the NOI calculation, those are not considered operating expenses.
Don’t forget to include income from laundry machines, extra fees for parking spots, or any service fees in your total income. Operating expenses include property manager fees, legal fees, general maintenance, property taxes, and any utilities that you pay.
The calculation excludes capital expenditures, taxes, mortgage payments, or interest. When using NOI to evaluate a potential investment, remember that projected rents could prove inaccurate. And, if the building is improperly managed, income could be inconsistent.
7. Capitalization Rate – Cap Rate
Cap rate is the real estate equivalent of the stock market’s return on investment. It’s the ratio between the amount of income produced by a property to the original capital invested (or its current value). It tells you the percentage of the investment’s value that’s profit.
Cap Rate divides your net operating income (NOI) by the asset value. When you’re in the acquisition phase, this will be the property’s sale price. Later on, you can use your local realtor, broker, or the estimated value on real estate websites.
Generally speaking, the higher the cap rate, the higher the risk. That is because a high cap rate indicates higher returns, and ultimately higher risk. This why you generally see higher cap rates in riskier markets, versus lower cap rates in stable and larger markets.
8. Cash Flow
Cash flow is a sign of how well your business is – or isn’t – doing. It’s your net cash left at the end of the month after you’ve received your rents and paid your expenses. If you rent a building for $2,000 a month, and all costs are $1,200, your net cash flow is $800. You can calculate this metric yourself.
Why does Cash Flow matter?
Net cash flow is a simple but important number. If it’s negative, you won’t be able to pay your bills or make a profit. Negative cash flow could also indicate that you’re spending too much on the property, and you should examine its associated expenses. Or, you may have a delinquent tenant whose late or partial payments are impacting your bottom line.
9. Loan to Value Ratio – LTV
The Loan to Value Ratio measures the amount of leverage on a particular asset. An LTV matters to buyers who finance their deals as it measures the amount you’ll need to finance against the property’s current fair market value. But, LTV is also the best way to track the equity you hold in a property (not just for financing) but for the value of your portfolio and assets accounting for debt.
For financing, most lenders will not finance up to 100% of a property’s value; they want to leave equity in it to protect their investment. They express how much of the total purchase price they’re willing to finance in a loan-to-value ratio.
The difference between the percent a lender will finance and the property’s total value is the amount of cash that you will have to put into the deal.
If the lender will do 80% LTV deals, you need a 20% down payment to secure the mortgage. In this scenario, a $100,000 property would require $20,000 as a deposit plus closing costs, and would represent an 80% LTV. After 10 years, if the value of the property is now $200,000 and you’ve paid down your mortgage to $50,000, your LTV would now be 25%.
10. Debt Service Coverage Ratio
Lenders also pay close attention to your Debt Service Coverage Ratio, or DSCR. It compares the operating income you have available to service debt to your overall debt levels. Divide your net operating income by debt payments, on either a monthly, quarterly, or annual basis, to get your DSCR.
If you’re applying for a new mortgage, lenders look at your DSCR to gauge your repayment ability. A high ratio indicates that you might be too leveraged and will make it harder to qualify for financing.
Why Does DSCR Matter?
Typical A and B lenders require a DSCR in the 1.25–1.5 range. This means that your rental property produces 25% more of additional income after debt service. A DSCR of 1.5-1.75 is even more desirable and could help lower your interest rate.
If you’re looking for your next property investment or development then contact us at Property Investment Deals.
