It’s no secret that purchasing good properties at the right time is a solid investment to get rich – purchase rental properties and collect income, while watching the property prices creep up.
Once the market is ripe, sell off the property to earn extra liquid cash! Sounds simple enough, right?
But while this is something many aspire to – and save money for years to put towards – too often, people get themselves into the property market without first weighing (or understanding) the risks and overall costs.
After all, if you buy a property and the price increases over time, did you know that it doesn’t guarantee that you’ll make a profit on your investment?
So, how can you ensure you make money in property?
The first thing is understanding the differing methods of calculating return in real estate transactions – two of the most common being;
- Cash-on-cash investments, and
- Return on investment (ROI).
Let’s check out the maths involved in both for a clearer picture.
Please Help, I Don’t Know Which Method To Use!
1) Cash-On-Cash Returns
In a nutshell, this method of calculation measures the yearly returns an investor (yep, that’s you!) can make on the property, in relation to the amount of home loan paid in the same timeframe.
Basically, it’s the physical cash you have in hand after 12 months, divided by the physical cash you’ve already invested.
It’s a common calculation, and is based on assuming that you’ll fund the bulk of the entire property investment (which is often not the case, as rental income does play a part).
Here is an example of a cash-on-cash formula:
Annual pre-tax cash flow (Net income)
Cash-on-cash return = _____________________________________Total cash invested
2) Return On Investment (ROI)
This is a method that includes both positive and negative cash flows in the calculation.
It’s basically working out the percentage of invested money that is recouped after deducting other associated costs (such as legal transactions, maintenance, taxes and insurance).
It also takes into account the rental income received.
To work out a property’s ROI:
Annual return (Gain – cost)
ROI = ________________________________
Amount of the total investment (Cost)
Cash-On-Cash Vs. ROI: How Do They Work?
There are many ways to understand the returns your investment property can deliver, and these are just two of them.
What matters most with cash-on-cash or ROI, is that you understand the limitations of certain calculations.
You should also give yourself enough wiggle room to deal with any economical instability, property fluctuations or unseen costs.
This method only measures the return on the actual money invested, giving you a more accurate overview of your investment.
Cash-on-cash is an easy and straightforward method of calculating any investment that involves long-term borrowing.
Because of its simplicity, using it is very quick to compare multiple investments, and it’s what many sellers and agents use when discussing potential returns on properties they are marketing.
Unlike cash-on-cash returns, ROI takes into consideration the money you spent for the down payments and the amount of cash you may have financed.
ROI can help in deciding between different investment opportunities. It can be used for calculating or comparing the returns of the past, as well as a signal for monitoring your investment.
It doesn’t include things like the money value of time and property appreciation, meaning cash-on-cash is a less accurate measure beyond 12 months of your investment.
Less accurate than other more sophisticated measurements like Internal Rate of Return (IRR) and Modified Internal Rate of Return (MIRR), which can provide greater insight.
Overall, the cash-on cash-return ignores many risks associated with investments.
Investment calculations based on ROI only consider the total return on an investment, which can be less accurate overall.
ROI can also be skewed because it might seem as though your return on investment is more when you have a home loan, than if you paid all cash.
This is why it’s a good idea to use more than one way of calculating investment before you purchase a property.
Examples Of Using Cash-On-Cash Or ROI
Let’s put this in a real world scenario so you can see the difference between the two methods of calculating investment.
We’ll assume the property purchase price is RM400,000 and other relevant costs associated with the property purchase totals about RM4,000.
In this scenario, the returns are the property sale price – let’s assume you managed to sell the property at RM450,000 – and rental income of RM4,000 per month.
If this property is sold in 12 months, we’ll make RM50,000 from the sale price/appreciation, and RM48,000 from 12 months’ worth of rental income. We also have a negative cash flow of RM4,000 in costs.
If we use this formula, we will find out our delivered return percentage:
(Sale price 450,000 + rental income 48,000) – (Purchase price 400,000 + other expenses 4,000)
Purchase price (400,000)
This works out to 0.235, or an ROI of 23.5%
Now, let’s assume a total purchase price on a property is RM1 million. You, as the investor, might pay RM100,000 cash as a down payment, and borrow RM900,000 as a loan from the bank.
You’ve got to pay closing fees, insurance and maintenance costs of about RM10,000, which comes straight out of your pocket.
In 12 months, you’ve paid RM25,000 in loan payments, RM5,000 of which is a principal repayment.
You’ve managed to sell the property for RM1.1 million at this time.
Your total cash outflow is RM135,000, and after the remaining debt of RM895,000 is paid, you’ve got a cash inflow of RM205,000.
This means that your cash-on-cash return would be RM205,000 – RM135,000 / RM135,000 = RM51.9%
Typically, an okay cash-on-cash investment would be around 8-10%, and a strong investor wouldn’t consider anything less than 20%. So in this scenario, it would be considered a good investment.
At the end of the day, you’re going to need to do your own homework. It’s important that you understand how these calculations work, and what their limitations are, to make sure you get the best deal for your investment.