Love the deal not the property!
The old saying is "Location. Location. Location." While picking the correct location for the purpose you intend to use your property is absolutely essential there is one more piece of analysis that is even more important. The financial analysis!
Do the numbers stack up? Is the deal worth it? Are you going to get the right return for you time, effort and risk? You may have found the best piece of real estate in the best street, in the best suburb, but if the numbers don't make it a profitable deal then it's a waste of time. Real estate investment is not about location it's about profits.
There are three standard methods used to assess whether a property is financially worth investing in or not. These are:
Yield:
Yield is one of those ratios that everyone, especially estate agents, seems to use but isn't particularly useful in property analysis. Yield is the annual income of an asset divided by the price of the asset. For example, if a $100,000 property produces $8,000 a year in rental income, it would have an 8% yield. Yield is used widely because it's a simple number to produce and understand. But it often hides more than it shows. Using yields on property is problematic for three reasons:
1. Ignores the power of leverage - leverage is a powerful reason why property is such an attractive investment. Looking at the $100,000 property again, let's say you invested $20,000 and borrowed $80,000 at 6% to buy the property. Yield doesn't help tell you what your return is on your $20,000? Yield only tells you what the return is on the asset itself.
2. Ignores the future - Yield doesn't take into account the increase in a property's price. Let's say, for example, that the $100,000 property price increases to $105,000 after one year. Yield ignores a property's capital growth.
3. Ignores costs - Yield ignores the costs involved in owning a property such as interest expenses and running costs like maintenance, property management, insurance, etc.
Cash-on-cash return:
Cash-on-cash return is a much more effective way to analyze your possible investment. It takes into account your borrowing costs and all expenses involved in buying and operating a property. Cash-on-cash return concentrates on what return you're likely to earn on your invested cash, not the asset itself.
Using our $100,000 property...the cash-on-cash return is focused on telling us our return on the $20,000 cash we invested, not on the $100,000 property value. Taking your income of $8,000 again, and this time assuming your interest and running costs total $5,500, what would your cash on cash return be? Your cash on cash return would be 12.5% (($8,000-$5,500)/$20,000)
The objective is to have a positive cash on cash return and the higher the better. If you analyze an investment and it generates a negative cash-on-cash return, walk away and move onto the next deal.
So, our yield was 8%, but the return on our cash investment is actually 12.5%, which means you've increased the return on your money when including leverage and costs. However, cash-on-cash return, like yield, doesn't take into account the future into account such as potential capital appreciation, rising rentals and costs. The yield and the cash-on-cash return take a snapshot or picture of an investment; they don't look at an investment's return over time.
Internal rate of return:
The internal rate of return (IRR) solves all these problems by taking into account your invested cash, the predicted returns over time and capital appreciation. It allows you to easily compare two differently priced and financed investments so you can decide which is superior. It also enables you to change variables such as the borrowing amounts and growth rates to see the effect on your return. The downside to IRR is that it's rather difficult to understand and calculate. But, thankfully, computers have made it a snap.
The textbook definition of IRR is "the interest rate that gives a stream of income a net present value (NPV) of zero." Wow! I prefer to think of IRR as "the interest rate I would have to earn on my investment to produce the same set of cashflows." Let's say that our $100,000 property cost us $20,000 today and it produced $2,500 profit in the first year, $3,000 in the second and $3,500 in the third. At the end of the third year, we sold it for $125,000, giving us $45,000 cash ($25,000 profit plus the initial $20,000 we paid). Taxes aren't included in this example. The IRR is 42%. This is simply the interest rate we would earn investing $20,000 to produce these cashflows.
IRR Example
Year 0 (Today) Cashflow -$20,000
Year 1 $2,500
Year 2 $3,000
Year 3 $48,500
IRR 42%
The yield on this investment was a pretty boring 8%. The cash-on-cash return looked far more interesting at 12.5% but still wasn't jumping out to grab us. However, the IRR is 42%. Now, that's a fantastic return on your cash! Why does the IRR give us such a different picture of exactly the same investment? Because the IRR takes into account the future, which includes the increase in rentals (and expenses) and the expected proceeds from the sale of the property in three years. Essentially, IRR takes into account all the cashflows involved in an investment over the entire period of the investment. It isn't just a snapshot; it looks at the complete story.
The investment with the highest IRR is obviously the preferred investment, as it means you're earning the highest interest rate on your cash. A good rule of thumb is that you should only consider investments that generate IRR above 20%. In the Wealth Tools section is the Property Investment Calculator spreadsheet which is free when you register which can do all the essential calculations in a millisecond and will ensure you're making a fully informed and profitable investment decision. Good luck with your real estate investing.
