Today we want to talk about investing in real estate and how many people think they are receiving higher returns on their investments than what they actually are. We feel this is a very important topic, because we see it all the time with family, friends and clients. That is why, we decided to finally write about it with the hope that you don’t make the same mistake.
We recently received a call from a friend that purchased a townhouse as an investment property at a local auction. He called very excited telling us how happy he was with his returns, so we had to ask: What is the Cap Rate on that property? He said, over 10%. So, we asked, is this after all your expenses? He said, well… yeah. His unconfident reply made us wonder if he even considered all his expenses. We had to dig deeper. The pen and paper came out and we began to drill… Since this was a gated community, we started with, how much are you paying for association and does it include insurance? Then, how much are your taxes, monthly loan payment, purchase price, closing cost and how much money did you put into the property for renovations after the closing? Then finally, how much have you collected in rent?
You see, a good way to calculate and compare the benefits of an investment, is through an easy formula called the Return on Investment (ROI). You simply divide your profits by the investment cost. So, on your real estate investment property; you would figure out your Net Operating Income (NOI) by taking your net income and subtracting all your operating expenses. Then you would subtract your debt service to get the profits the property is generating. Then divide that number with the investment cost and presto… you have your ROI. (Multiply by 100 to get a percentage)
Make sure to include purchase price along with closing and renovation costs. This is very important, especially for comparing investment opportunities. If Mike buys a property with a purchase price of $100,000 and Jimmy buys another property at $120,000 and they both collect $10,000 annually after paying all their expenses including debt service. Most people would say, Mike got a better deal. What if we tell you that Mike paid $60,000 between closing cost and renovations, while Jimmy only paid $15,000. That would change things, wouldn’t it? Well if you are not sure, just figure out their Return on Investments and compare. Mike’s ROI is 6.25% (10,000 ÷ 160,000 x 100) and Jimmy’s ROI is 7.41% (10,000 ÷ 135,000 x 100).
Well, back to our friend’s phone call… after going through all his expenses and how much he paid for the property, including the closing and renovation costs, he was shocked to find out that the return on this investment was just under 4%.
Unfortunately, a lot of people out there are in the same situation as our friend. We meet people all the time that think they have a “great” investment. We do not like to be the bearer of bad news, but after running the real numbers they find out they are not profiting as much as they thought and in some cases just breaking even. This can easily happen by overpaying for a property, going over budget on renovations, or collecting under market rents.
Though everyone wants to have a “great” investment. We want to encourage you to be honest with yourself and run the real numbers to figure out the Return on Investment. We hope that this will assist you to compare opportunities to make an informed decision on your next investment. If you have any questions or would like an in-depth analysis on your investments, please feel free to contact us and we will be more than happy to assist you.
Your Trajan Investment Team – Assisting Commercial Real Estate Investors to Prosper!
Trajan Investments, Inc. A Commercial Real Estate Brokerage and Consulting Firm.