The Only 4 Real Estate Investment Metrics You Should Care About
It is estimated that around 75% of rental properties in the US are owned by individuals, or “mom and pop” landlords. While there are some institutional investors that buy small properties such as single-family homes and small multi-family housing, most institutional investors focus on larger investments. These institutional investors have armies of MBAs buried in spreadsheets to help analyze every aspect of an investment. They look at market trends, calculate risk tolerance, and even consider currency exchanges to help panels of decision makers decide where and what to buy. Some of the things they calculate are internal rate of return (IRR), cap rate, and net operating income (NOI). These are very sophisticated terms, and no doubt helpful to some extent. But does the average real estate investor, the 75% of all rental property owners, need all those metrics to make a decision?
I don’t think they do.
There are countless books, blog posts, and calculators out there spewing forth a head-spinning amount of financial metrics for the real estate investor. Personally, I enjoy reading and learning about these types of metrics, but do I use them in my day-to-day investing? Does the average investor need them? Definitely not!
On the other hand, I talk with countless individual investors who don’t have the slightest clue about how to analyze their real estate investments. Some of these people have a clear grasp of the stock market, how bonds and CDs work, and even the time value of money. But for some reason, when it comes to property, they aren’t sure where to start.
In case you have a specific question, or want to skip ahead, here’s an outline of our guide on real estate investment metrics:
Table of Contents
Disclaimer: This post is for informational purposes only and does not provide legal, accounting, or financial advice. I am not a lawyer or accountant. Visitors should not rely upon this information as a substitute for legal, accounting, or financial advice. While I make every effort to provide accurate website information, laws can change and inaccuracies happen despite our best efforts. If you have a specific problem, you should seek advice from a qualified professional in your own jurisdiction.
Why should amateur real estate investors care?
There are 2 main reasons small time real estate investors should be financially literate about their properties:
1. Opportunity cost
There is a time and financial commitment required to be a real estate investor. Even if you have a property manager, you may have to write a check every once in a while. At the very least, your taxes are slightly more complicated. The main opportunity cost is the money invested. Investors have an endless array of places they can invest their money. Even the most simplistic investor wants to get the highest amount of return for the least amount of risk. If you can earn twice as much money by having your money in another investment of equal risk, don’t you want to do that?
2. Know if they’re losing money
The open secret about many small businesses is that they don’t actually know how much money they’re making. And many of them are losing money unknowingly. This is made especially difficult when you consider how we do income taxes. We want to minimize our tax bill, and the way we do tax accounting isn’t reflective of reality.
Before I get started, I want to mention that investors of all types invest with various goals in mind. Your goals will drive what metrics you look at in your investment portfolio. With that said, most real estate investors I talk to fall into two buckets: they are trying to grow their net worth (planning for retirement), or trying to live off their savings (retired). These two groups of investors with vastly different goals will look at these metrics differently. In this article, I will explain which are most important to each group.
The most important real estate investment metrics
There are 4 numbers the average investor needs to be calculating on a regular basis (yearly at least), and clearly understand. They are:
- Cash Flow
- (Total) Return
- Return on Investment (ROI)
- Return on Equity (ROE)
Let’s look at each in detail and discuss the importance of each.
1. Cash Flow
Cash flow is the amount of money added (or subtracted) from your pocket each year after all rent is collected and all expenses are paid. If your tenants pay you $10,000 a year, that’s great…unless you pay $15,000 in mortgage payments, insurance and taxes.
In simple terms:
Cash flow = Rents collected – ALL expenses
If a property is cash flow positive, this means that you will make money after all expenses are paid. If a property is cash flow negative, then you’ve spent more money on the property than you’ve received in income (you’ve LOST money).
The mistake most people make when calculating cash flow is that they only look at their mortgage payments. If the mortgage is $1,000 a month, and the rent is $1,100 a month, its easy (and wrong) to conclude that the property is cash flow positive. This is a typical mistake in underestimating expenses.
Unfortunately, as anyone who’s owned real estate for more than a month knows, there are many more expenses beyond just the mortgage payment. You will also pay for repairs, maintenance, property management, leasing, and taxes.
Another big “hidden” expense is vacancy. If the property sits vacant for a month, that’s an entire month’s worth of rent that you will never receive. Many landlords will also have to pay utilities while the property is vacant. You won’t necessarily plug in “vacancy” to your expenses, but when projecting the amount of rent you’ll be collecting, you should include a realistic number for vacancy. Vacancy rates differ by real estate market, but the typical vacancy rate for your area should be easily found online.
Always plan in worst case scenario or add a buffer on top of your expected expenses. Bad things do happen. For example, what happens when you have to evict a tenant or the tenant dies? These things do happen.
Why is knowing cash flow important?
Having positive cash flow significantly reduces the risk to a real estate investment. Think about it, the house could lose value, the economy could crash, you may lose your job…but your real estate investment will be safe because the income more than covers all expenses. Cash flow means you won’t be faced with foreclosure or its alternatives.
Another benefit to positive cash flow is that your bank account grows each month. This is more money in your wallet that you can use for living expenses…or to reinvest into more real estate!
NOTE: I want to highlight here that cash flow is only looking at one aspect of the investment. There are many investment strategies that accept a negative cash flow. For example, if you buy a piece of land, expecting it to appreciate, you’re going to have negative cash flow. Many income-producing assets, like houses, will have negative cash flow as well. Many investors who invest for appreciation are okay with the negative cash flow. The key is knowing that and making that conscious decision.
Who cares most about cash flow?
Retired investors are the ones who must be looking most at cash flow. The cash flow from their rental properties is likely feeding their lifestyle and their day-to-day expenses. For the retired investors, they’ll need to monitor cash flow, because in many markets, houses will appreciate faster than rents. This means the taxes may be going up faster than rent, eating into cash flow. Add on top of this increased maintenance and repair costs as the property ages and cash flow will often go down over time on a fully paid off property.
2. Total Return
Why do some investors accept negative cash flow and the risk that comes with it? Because while cash flow is an important metric, its only part of the picture of the total return, which is made up of:
- Cash Flow
Wow it seems like things just got a lot more complicated! Stick with me… let’s look at each of those four things and how they contribute to your return.
Appreciation is pretty easy to understand. It’s the amount that your property increases in value each year (assuming it goes up!). So if you have a $100,000 house, and after a year its worth $110,000, you’ve just earned $10,000 in appreciation. You would say that your house appreciated 10% in value.
What if value of property goes down?
Houses generally rise in value, but of course there are many cases when a property value will decrease. While technically you could call this depreciation, most experts will refer to the numbers as negative appreciation. So if a house’s value went from $100,000 to $90,000 in value, a lot of people would say the appreciation is -10%. It’s more common to say the house declined in value or lost value. Typically, you wouldn’t refer to this as depreciation, since depreciation is more broadly used for another situation:
You’d think depreciation would be the exact opposite of appreciation, or would describe situations where your property went down in value. That’s not really the case, although it is related.
In terms of calculating your total return, depreciation refers to how much you’ve depreciated your house on your tax returns. So it’s simply a tax accounting term and is set by tax rules.
Example of Depreciation
Each year you own a property, you’re allowed to depreciate its value for tax purposes, for up to 27.5 years. This will then show up on your tax returns as a loss for each year.
Obviously, this is entirely a paper loss because after 28 years, for IRS purposes, your property is worth $0.
In real life, with real money, after 28 years your property has probably appreciated fantastically.
Because you can depreciate your property on paper, and thus show a loss on your tax returns, you decrease your tax bill.
So when calculating your total return on an investment, you need to also consider how much you’re saving because of depreciation. Seems incredibly complicated, but the formula is simple:
Return from depreciation = (Initial property value/27.5)*tax rate
The most you can depreciate your property is the amount you paid for it, so you will only depreciate the initial property value. Since you will depreciate over 27.5 years, each year your loss due to depreciation will be (Initial property value/27.5). Given this is your loss, your tax bill will be reduced by that amount times your tax rate.
A few caveats to above: If you’re not an accountant, it’s okay to pencil this number out to estimate your return, but don’t try it on your taxes. There are some intricacies to my description. For example, you can’t depreciate the land value of the property, but you will be able to depreciate the value of the structure and any capital expenditures, like a new fence or appliance. I only bring this up because the amount you depreciate yearly will change; in addition, your tax rate may change from year to year, thus affecting your overall savings from depreciation. It definitely pays to hire an accountant to make sure you’re getting all the depreciation you can while playing by the rules.
Cash flow was described above and is its own metric that should be tracked. It also needs to be factored into your total return. If a property is cash flow positive, it will increase your total return. If your property is cash flow negative, it will bring down your total return.
Amortization is a fancy word for ‘paying down the debt.’ Every time you make a loan payment (on most loans), the total amount owed goes down. This is the loan being amortized, and eventually the loan will be paid off. Even if your property doesn’t go up in value you will have some return through amortization, because the amount you owe is going down. Your net worth is going up.
Example of Amortization.
You owe $100,000 on a house. After paying the mortgage for a year, you owe $95,000 on the house. Your total return has increased by $5,000 through amortization.
Why is knowing total return important?
A lot of people know to look at the property’s appreciation when thinking about how their money is growing, but fail to account for the other benefits of real estate investing. To get an accurate view on the money you’ve invested, you need to consider amortization, depreciation, and cash flow as well.
What if your property is appreciating at 5% per year but you’re cash flow negative, there’s no loan and you’ve already fully depreciated the property? You might think you’ve got a great investment if you just look at appreciation, but once you include these other factors, that investment might not be so great.
Looking at total return will help you see the full picture on how your investment is growing. I like to think of total return as how much my net worth is increasing each year. I might be cash flow negative on a specific property, but if my total return is increasing, I know my net worth is going up and I’m making money on that property.
3. Return on Investment (or ROI)
In simple terms, “return on investment” is the total amount of money you make on the money you’ve invested. If you invest $1000 and your return is $100, that means your ROI is 10%.
The math formula you should use is ROI = Return/Investment.
Seems simple, right?
We’ve already looked at how to calculate return. “Investment” is another term that seems easy to comprehend, but one that many investors will mess up or misunderstand. Let’s take a closer look.
Investment is the amount of money you’ve put into the property (out of your pocket). Its fairly easy to calculate, especially at the beginning.
Some examples: Same house, different investments
In the simplest example, you buy a house for $100,000 cash.
That means your investment is $100k.
On the other hand, if you buy the same house by putting $20k down on a mortgage, your investment is only $20k (even though the house you’ve just invested in is worth $100k).
If, after buying the $100,000 house, you spend $10,000 renovating it, you should include this $10k in your total investment number, assuming the $10k came out of your pocket and wasn’t included in a loan.
Don’t forget to include rehab costs and other make-ready expenses as part of your investment, because when you’re calculating your Return on Investment, you want to take that into account. You might have gotten a killer deal on the property but it might not be such a great deal if you have to plow a ton of money into it to make it livable. If you hadn’t put that money into the property, you could have put it into a savings account, or a stock instead.
It’s important to keep in mind that you should only think of the ‘investment’ as the amount coming out of your bank account. If you are able to buy a house, fix it up, then refinance all your money back out, it’s possible that you’ll have an investment of $0, or even less. In this case, the original money you invested isn’t tied up in the house. In fact, it’s available to use again to repeat this process.
A lot of real estate investors do this (referred to as BRRR : buy, rehab, refinance, repeat). When I do this, I would only consider the original money I still have left in the property after the refinance to be my “investment.”
Why is knowing return on investment important?
Return on investment should be considered when deciding which asset to buy. It should also be used to compare across asset classes. If your real estate investment will have an ROI of 5%, you’re better off buying a bond with a 5% coupon, which comes with a similar amount of risk and a lot less headache.
Unfortunately, Return on investment isn’t a valuable metric when it comes to deciding whether to sell. For that, you need to look at Return on Equity.
4. Return on Equity (ROE)
Return on equity is a measure of how well the money you have tied up in the house is performing. It’s commonly referred to by some businesses as “return on assets.”
The math formula you should use is ROE = Return/Equity.
Equity is the amount of money you have tied up in the property. It’s also referred to as ‘assets’ in other businesses. It’s simple to calculate: take the value of the property and subtract any debts you have. That is your equity.
A house worth $100,000 with a $25,000 mortgage has $75,000 in equity.
Another way of looking at equity is, this is the amount of money that would go into your pocket if you sold the property today.
When you first buy a property, the investment and equity will be the same number. As time goes on, however, equity will grow as the property rises in value and the debt is paid off.
After you’ve bought the property, equity is never clearly known. It will always be a rough estimate, until the actual property is sold. The reason is that, while you may know exactly how much debt you have, you are never sure of the exact value of the property. You can get an appraisal every year if you want, but that’s silly and costly, plus even the best appraisers will give you a range for the value of the property.
So you will have to take your best guess. My recommendation here is to just use the same method every time you calculate equity. If you are happy with the Zestimate, just use that each time. Using the same method each time will give you a better idea about how your property is changing in value over time.
Why is knowing return on equity important?
ROE is the number you should refer to when deciding when to sell or refinance a property. The equity rises every year you own a property. Your amortization also decreases each year as you pay off the mortgage. Eventually you’ll also run out of depreciation.
What this means is that your ROE will fall over time.
At some point you will be better off selling (or refinancing).
Let’s look at an example:
You buy a $100,000 house with a 20% downpayment that has a return of $5,000. Your investment is $20,000 (your mortgage is $80,000). Your equity in the house is also $20,000.
ROI = ROE = $5,000/$20,000 = 25%. Not too shabby!
Fast forward 30 years, the house is worth $500,000, the loan is paid off and you’ve depreciated it to $0. That means you have $500,000 in equity available. Let’s assume the return has also gone up by 5x, to $25,000.
ROE = $25,000/$500,000 = 5%. Ugh!
In this example, your return on equity starts off great, but after time dwindles to a measly 5%. You’re better off taking that money out and investing in a better investment, especially when you consider this property was earning you 25% when you first bought it.
By The Way…
Paying taxes will seriously eat away at your returns. Luckily, there are many ways to protect you real estate returns from taxes. One strategy is the 1031 exchange which involves trading your property for another. Another strategy is to sell an inherited house soon after it comes out of probate, since the tax basis is reset upon death
Who cares most about return on equity?
Investors who are trying to build their net worth should look at ROE above all other measures. This is telling them how hard their money is working for them. How fast the money they have tied up in a property is growing. If that money isn’t growing fast, it needs to be reallocated.
On the other hand, someone who’s retired and living on a fixed income might not care much about ROE as long as they have healthy cash flow. In the most recent example, $25,000 a year at a 5% return might be great if most of that return is cash flow.
Other interesting, but less important (in my opinion) metrics
This is the cash flow you’re going to get compared to the cash you’ve invested. It’s similar to a dividend payment if you buy a stock, or a coupon payment on a bond. This is interesting to measure, and obviously you want this to be a healthy number. But I don’t pay too much attention to it since it doesn’t capture the true return of an investment. It doesn’t consider factors like appreciation or depreciation. Still, it is a good indicator as to whether your cash flow is healthy, and will help you compare two separate investments in terms of cash flow.
This is another way to look at cash flow. The payback period is how long it will take you to get your initial investment back from the cash flow. In fact, the mathematically minded will recognize that payback period is simply the inverse of the cash-on-cash return. If the cash-on-cash return is 5%, it will take 20 years to get your initial investment back (from the cash flow alone).
There are tons of other interesting metrics that are available to real estate investors. Some, like IRR, Gross Rent Multiplier, Cash-on-cash returns can help you understand your investment better. Others, like net operating income and cap rate, are really only used by commercial or professional investors. Having these numbers handy will help you understand your investments better, but aren’t really necessary for the average investor.
Does the average investor really need 37 metrics? No, they really only need two to three important ones. As long as you clearly understand your cash flow, ROI and ROE, you will have a clear picture on how your properties are doing and be able to make the right decisions to meet your investment goals.
Need help calculating all this? Fill out the form on the contact page and I’ll share the spreadsheet I use on my own investments!