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INVESTING 101 EDUCATION

How to Calculate a Good Investment Property

Before you make any investment, you’ll want to run the numbers to determine if it’s a smart investment. Learning how to calculate a good real estate investment property is the key to ensuring that your money is actually working for you; that you’re leveraging it properly. For some newer investors, how to calculate a good investment property can seem confusing. While it’s true there are multiple factors that determine if an investment is worthwhile, there are some hard and true methods you can learn to calculate the potential value of any real estate investment you’re considering.

What is ROI?

The first thing to look at is the Return on Investment, or ROI. ROI is an overview calculation that you can quickly run to determine the percentage gain you could make on an investment. ROI is calculated as a percentage of the amount the investment is costing you. It doesn’t tell you everything you need to know about the possibility of a good investment, but it’s a starting point.

How to Calculate Return on Investment

Calculating ROI is fairly straightforward. It’s a matter of money in, money out. However, ROI isn’t a calculation of profit; it’s a calculation of net return. Therefore, you could have a negative net return on an investment that you actually made a profit on.

Here’s exactly how to calculate ROI:

(Net gain on Investment – Cost of Investment) / Cost of Investment = ROI

For example, let’s say you bought an investment property for $50k, put an extra $12k into it for rehab and then sold it for $120k. The ROI calculation would look like this:

($58,000 – $62,000) / $62,000 = ROI of -6%

Understanding ROI

This is where newer investors get confused. On the surface, it looks like a great investment. You put in $62,000 and sold it for $120,000, so you made a profit of $58,000. Great, right? Then why does the ROI come out as a negative number?

Because ROI isn’t calculating profit. It’s calculating return on investment. When the ROI is a negative number, that indicates that the investment results in a loss because you put in more than you got out.

Think of it in terms of leverage. When you successfully leverage your money, you get out more than you put in. In the case of a negative ROI, you put in more than you got out. In the end, a negative ROI indicates that your money didn’t work for you.

Calculating a Good Investment Property

Of course, with real estate investments, there are a number of variables that have to be taken into account in order to tell if it’s a good investment property, particularly if you plan on holding and renting out the property.

First, most people don’t pay cash outright for property. They make a down payment and finance the rest. That financing costs money. Second, there are supplemental expenses to factor in for any investment property, whether you’re flipping it or holding and renting it. You have to pay for insurance, closing costs, commissions and so on.  And if you are holding the property and renting it out, you need to factor in repair/maintenance costs, property management fees and more.

All of these expenses influence cash flow from the investment rental property.

How to Calculate Cash Flow

Cash flow is a deceptively easy formula. On the surface, it’s a simple calculation that looks like this:

Total Income – Total Expenses = Cash Flow

However, each of these factors, total income and total expenses, can in themselves by complex.

Total income would be rents received, obviously. But you may have other sources of income from a rental investment property, such as tenant application fees, late fees, excess utility fees if tenant pays a lump sum each month, parking space/storage unit rental fees, money from a coin laundry on the premises, lease income from vending machines, etc.

Total expenses gets very complicated. You need to consider all the expenses you incur from a rental property if you want to accurately calculate cash flow potential. Expenses may include:

  • mortgage
  • closing costs
  • property insurance
  • private mortgage insurance
  • special hazards insurance (flood, earthquake)
  • utilities
  • property management fees
  • repairs/maintenance
  • replacements (HVAC, appliances, fixtures)
  • property taxes
  • HOA fees
  • travel (gas, flights)
  • advertising
  • hardware/software
  • bookkeeping/accounting services
  • and more…

There are intangibles that need to factor in that aren’t as easy to assign a number to. These include your time. You can greatly reduce this cost by hiring a real estate investment property manager.

When calculating cash flow, remember to prorate income and expenses that don’t occur monthly so you can be sure to get an accurate number.

More Ways to Calculate a Good Investment Property

Remember, there are at least six ways that a real estate rental property can pay you. When you invest in real estate, you get added tax deductions you can use to offset income from other sources, you get the benefit of having your loan paid down by your tenant and you get depreciation and equity capture, as well as other benefits.

All these things need to be taken into consideration when you’re looking at whether to invest in a real estate investment property. Takeaways include learning how to leverage your investment dollars so they work for you and not against you, even if it appears you’re making a profit and learning all you need to include when calculating cash flow. Finally, the most important calculation of all; figuring out how the investment will affect your personal lifestyle. Will it give you extra discretionary income, or time with your family to do the things you want to do? For more information about residential and commercial investment opportunities, please contact American Real Estate Investments.