A simple way to evaluate investment property
There are numerous ways for any property investor to evaluate a piece of investment real estate. One could choose from such tried and true methods such as calculating the net present value of an investment, or figuring out the potential internal rate of return on the real estate you’re considering acquiring. Unfortunately, both of these methods require making a grand estimate of the future sales price of the property. Many investors choose the gross rent multiplier method, which I have written extensively about in another article. But the simplest method I have found that works quite well is the cash on cash method.
Conservative numbers crunching
The concept is simple enough: determine a conservative cash flow for the potential property (and never use figures supplied by the seller, unless they are exact numbers that can be verified). Once you’ve crunched your set of conservative numbers (including all potential expenses on the property, as well as the current rent roll), divide that cash flow into your actual cash amount you’ll be putting into the deal. You’ll then be able to see a very true picture of your cash return on your investment – exclusive of what the property will fetch when you go to sell it down the road. (Trying to calculate appreciation continues to be a dicey way of evaluating a property these days – many parts of the U.S. are experiencing a rebirth in valuations, while others continue to stagnate. Remember, all real estate is local. Pay no attention to national figures for appreciation.
Cash return example
As an example of the cash on cash return method at work, consider you want to acquire an investment piece of real estate for $100,000. Assume the property will throw off a conservative positive cash flow of $3,000 annually. If you put 30% down on the property, and therefore invested $30,000 of your own money, the return on investment would be 10% ($3,000/30,000).
Naturally, due to the greater risks and larger amounts you’re investing, you’ll be looking for greater returns. And they should be much more than other types of investment vehicles, including other forms of real estate investments, such as Real Estate Investment Trusts (REITs). REITs offer much less overall risk than individual property ownership and management. Unless you’re specifically trying to offset other income by buying negative cash flow property (where the aim is to use investment property as a tax shelter), you shouldn’t be considering wasting your time on investment properties with cash on cash returns below five percent. There’s simply too many things that can go wrong for you to accept a smaller ROI. Always remember to analyze your numbers conservatively, and stay above five percent ROI. This simple method will then hold you in good stead as you move forward in making new property acquisitions.
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