If you have struggled to determine whether or not your rental property is a good investment, or to compare your real estate investment with other asset classes, you are not alone. In this blog post, we will go over some commonly-used performance measures and how to calculate them.
We will define terms so that you can assemble a Pro Forma (latin for “as a matter of form”, basically a forecast of income and expenses) on your own, and then provide you with a template that you can modify to include your own assumptions and projections.
Let’s start with some definitions of terms used in the pro forma:
Rental Income: Defined as the total rent that would be received if the property had zero vacancy or loss to bad payments. Basically, multiply the monthly rent by 12. If a property rents for $1,000 / mo, the total rental income would be $12,000.
Late Fees: If you anticipate receiving late fees, that would be additional income.
Vacancy Allowance: Income that was not received as a result of the property being vacant, or a rent payment that was uncollectible.
Cleaning and Maintenance: Does not include repairs. Include such items as cleaning prior to renting, yard maintenance, tree trimming, etc.
Commissions: Leasing commissions in many cases may be 50-100% of one month’s rent.
Legal / Professional Fees: Include accountant and lawyer fees.
Management Fees: If you utilize a professional management company, this will normally be 8-10% of rental income received.
Repairs: This includes plumbing, electrical, heat and air, etc. Do not include “Capital Expenditures” such as a new roof, as they are not expenses.
Utilities: Utilities paid by owner as part of the lease or during a vacancy.
Net Operating Income – Defined as gross potential rents minus all operating expenses. Do not include mortgage principal and interest in operating expenses.
Pretax Cash Flow – Defined as Net Operating Income minus mortgage principal and interest payments.
Capitalization Rate – Defined as Net Operating Income divided by initial acquisition cost. If NOI is $10,000 / yr and the total acquisition cost is $100,000, the Cap Rate would be 10%.
Cash on Cash Return – Defined as Pretax Cash Flow divided by initial investment. Let’s say you put 20% down on a hypothetical investment property purchased for $100,000, or $20,000. If Pretax Cash Flow is $2,000 in year 1, your cash on cash return would be 10%.
Internal Rate of Return (IRR) – Defined as the annualized effective compound rate of return that makes the net present value of all cash flows (positive and negative) equal to zero. Whew!
You can use a spreadsheet program to determine the IRR. IRR can be used in comparison with an established minimum rate of return to determine if an investment is acceptable. For instance, if I assume I can generate a 12% return elsewhere with the same level of risk, I might accept a real estate investment that is greater than 12%.
More information on IRR can be found here.
Net Present Value (NPV) – Defined as the present value (PV) of a time series of cash flows, both incoming and outgoing, of the same entity. This measure requires the use of a discount rate, which can be thought of as the rate of return that could be gained on an investment with similar risk levels. If the NPV of the investment is greater than 0, it can be said that the investment will add value, while if it less than 0, the investment may be rejected because it will decrease value.
More information on NPV can be found here.
OK, enough with the complicated definitions already!
The bottom line here is you, the investor, must determine which measures are most important to you. Each measure should be taken in context with the other measures of performance and evaluated as a whole to determine if the investment meets your criteria.
Here is an Analysis Pro Forma to get you started. Modify the cells in green with your own assumptions and figures.
Please note the above information and spreadsheet are for educational purposes only and while we endeavor to make it as accurate as possible, we offer no representations or warranty of any kind, express or implied.
If you would like a professional property manager to speak with you regarding your investment property and learn how Home Finders Leasing and Management, Inc can make your rental property “Hassle Free”, call us today at 918-665-0212.
I hope you have found this information useful and now have a better understanding of how to measure the performance of an investment property.