Using just one profitability metric is a recipe for disaster. Instead, you should always use a combination of two or more complementary metrics. That is because every measurement has its shortcomings. Unfortunately, many of these terms and acronyms appear unnecessarily complex to beginning real estate investors. To determine if real estate profitability is good, they usually end up using simple performance measures, like the total cash flow of a property.
Now, the total cash flow of the property isn’t a bad metric at all. In fact, you could say it’s one of the more essential profitability measures to check if the goal is passive income. A cash-flowing property can likely sustain itself through economic downturns than an otherwise purely appreciating property, so it certainly is an important number to track.
But, as a standalone metric, it falls apart because a larger property in the same neighborhood will probably bring in more cash flows than an otherwise smaller property. That doesn’t always mean the larger property is better. Some of the essential considerations you should be aware of are:
- how different sized properties compare to each other,
- the total investments you’ve made into the property,
- your legal claims on the property, and
- how your real estate investment compares to another asset class like stocks.
This is a list of profitability metrics that help answer these concerns.
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Cash flow per unit
Pros: Easy to calculate; intuitive
Cons: Can be manipulated by investing a large amount
Just as it sounds, cash flow per unit is the total cash flow receipts of the property over the number of units — where “cash flow receipts” are equal to your rental income (and auxiliary income) less operating expenses, financing costs, and capital expenditures. We can also say it is the net operating income less financing costs and capital expenditures, or basically the money you have left after paying for the investment property loan and major repairs.
A higher number is obviously better. $1,000 per unit is better than $100 per unit, assuming all other things remain the same — same class, location, life, vacancy rate, etc.
In terms of profitability measures, the cash flow per unit metric brings more value than the total cash flow of the property. Knowing your cash flow per unit is helpful because it shows how the property’s profits can scale. It’s a quick-and-dirty way of checking which property is more profitable for a given investment.
But this, too, means very little if we don’t contrast the cash flow coming in with our actual total investment. For example, let’s assume both options have 10 units. The $1,000 per unit apartment costs $100 million, and the $100 per unit apartment costs just $60,000. The $1,000 per unit multifamily property doesn’t seem like a good deal at these investment amounts after all.
Fortunately, the cash-on-cash return addresses this issue.
Cash-on-cash return (CoC)
Pros: Considers both the cash received and cash invested
Cons: Does not consider non-cash returns
The cash-on-cash return shows you how much money you’re getting back, in percentage terms, relative to the amount of money you’ve invested.
(If you’re not sure how percentages work, have a look at this guide on Finance for People Who Hate Math.)
Suppose the annual cash flow of your property is $10,000. Let’s also say you put in a total of $125,000 to get the property up and running — purchase price, closing costs, etc. Your cash-on-cash return is:
CoC = $10,000 / $125,000
CoC = 8%The 8% return is what you get for investing in the property. Over one year, you can compare this to what you would’ve earned from a bank deposit, a stock that gives dividends, or other investments that generate cash.
That said, measuring profitability should be more than just about the recurring cash you expect to receive. Your asset’s unrealized and non-cash appreciation is also important. The return on investment (ROI) metric takes up this shortcoming.
Return on investment (ROI)
Pros: Accounts for the total investments you’ve made into the property
Cons: Can be a misleading indicator, particularly with smaller amounts; not a good measure over time
While CoC considers your cash flow as a percentage of the total cash invested, the ROI also accounts for your property’s appreciation, debt payments/mortgage payment, and tax savings, if any. And when measuring real estate’s performance, these non-cash items can be significant sources of returns.
ROI is computed as:
ROI = Total returns / Total investment
ROI = (Cash flow + Appreciation + Debt payment + Tax savings) / Total investmentBecause it is a percentage return, it is also comparable to alternative investments. But beware of mindless comparisons though. ROI typically rises over time and is best contrasted with what you actually own on the property, called your equity.
(Related: The Unfortunate Truth About ROI and Payback-Period)
Return on equity (ROE)
Pros: Good measure to track over time; shows your claims on the property
Cons: Relies on assumptions about property value
Return on equity is very similar to the return on investment metric, except you’re measuring returns as a percentage of the equity you own on the property.
Equity is equivalent to the value of the property less what you owe (i.e., your debt) on the property.
ROE = Total returns/ Total equity
ROE = (Cash flow + Appreciation + Debt payment + Tax savings) / Total equityIt is a handy metric for knowing when to sell or refinance a property. Specifically, ROE tends to drop over time (but not always) simply because you pay the investment property loan over time. At a certain point, it drops enough to justify moving your money away from the investment. I understand that can be pretty vague without specifics, so here’s a blog post on using ROE as a signal: Should You Sell or Keep an Investment Property.
One Percent Rule (1% Rule)
Pros: Easy to compute; filters out bad investments
Cons: Doesn’t consider expenses
The one percent rule says a good rental property should yield monthly rent of at least 1% of the purchase price. So if a property costs $100,000 to buy, we can reasonably expect monthly rent to be $1,000.
Having something like the one percent rule means you avoid spending time analyzing bad deals. Although not perfect, it is especially useful for quickly separating the deals with potential. I’ve found it too restrictive in my market, though, so I use a 0.8% threshold instead.
(Related: Using the 1% Rule in the Philippines: A Rental Property Rule of Thumb)
It is also helpful in adjusting your rents. If you can estimate the value of your rental property, then you can determine what reasonable monthly rents should be.
Net Present Value (NPV)
Pros: Tangible number that is expected to add to your net worth; considers the time value of money
Cons: Heavy reliance on forecasting
While it’s rare for a casual real estate investor to use NPV in analyzing real estate, it is the preferred tool by finance professionals for analyzing different investments — plus, you’re moving away from being casual investors, right?
(Related: Building Wealth With Real Estate Through Property Accumulation)
NPV is the theoretical value that’s added to you when you decide to take on a project. You know real estate generates future cash flows. So suppose we convert these future cash flows into today’s money and then compare that against the money you’d have to spend. The result is either a net positive or negative effect, where “positive” is when the total money coming in is more than the money coming out (i.e., positive cash flow). A positive NPV means the benefits exceed the costs.
However, NPV isn’t a good tool due to its heavy reliance on forecasting. But then again, NPV is best used as a checking mechanism. Suppose you know rents should be X when the growth rate is Y, and operating expenses are Z just to get to your value. In that case, you can then assess if those assumptions are reasonable or not — and, in turn, assess if the estimated value is reasonable or not.
Also, the actual computation isn’t complicated due to spreadsheets that have this function built-in.
Internal Rate of Return (IRR)
Pros: Yields a metric that’s comparable to other investments; considers the time value of money
Cons: Heavy reliance on forecasting; can be intimidating for beginners; assumes reinvestment at the same rate
NPV and IRR go hand-in-hand. IRR is the discount rate that results in an NPV of zero. Since we want a positive NPV, we accept projects with an IRR that’s higher than your required return. We can think of the required return as the return you want to get on an investment. If a stock’s returns are higher, then you’re better off buying stocks, like a REIT (real estate investment trust), than investing in real estate.
Like the NPV metric, spreadsheets have the IRR function built-in. Due to the complexity of commercial real estate, IRR is also one of the performance metrics monitored by commercial brokers and investors. (The modified IRR is an alternative that makes sense for some.)
Assessing real estate with more than one metric
Financial metrics are best used in conjunction with each other. The cash flow per unit, CoC, ROI, ROE, 1% Rule, NPV, and IRR contribute to the bigger picture, increasing your chances of buying a good investment. While it’s tempting to simplify the process with straightforward measures, doing so may end up costing you more in terms of investment opportunity costs.
I recommend using more accessible measurements to filter prospects first. Then apply the more advanced profitability metrics on deals that make your final cut.
