What Is The Difference and Which One is Better?
How do you compare two investment properties side by side to determine which is the best investment for your hard earned dollars? The answer to this question is likely very complicated because there is a lot that goes into an investment decision. When I look at a new rental acquisition, I will look at several things including; risks, likelihood of appreciation, ease of liquidation, amount of time required, etc… With all that said, there are two numbers I look at before I spend too much time on any one deal. I look at the Cash on Cash return (COC) and my Return on Investments (ROI).
Cash on Cash: This is probably the simplest and fastest way to look at a return. There are several restrictions to this formula, but I love it because it is a down and dirty snapshot of your rental property performance. Your COC is simply your annual profit / the amount of your investment. To keep this real simple lets use a $100,000 house as an example. If you buy this house with an 80% loan, you will have a $20,000 down payment. Because most of us are in beat up home business, let’s assume this house needs $20,000 of repairs to make it rent ready. To further keep this simple we are going to assume that it rents for $1,000 a month and your payment with taxes and insurance is $555 a month. (30 year loan with a 4.5% interest rate and $150 a month for taxes and insurance)
- Purchase price – $100,000
- Down payment – $20,000
- Repairs – $20,000
- Rent – $1,000 per month
- Monthly payment – $555 per month
The simple calculation is annual profit $5,340 ($445 cash flow * 12 months) / $40,000 (down payment plus repairs) = 13.35% COC return.
To make this more sophisticated you will also want to account for maintenance, vacancies and other expenses which are not included in this example.
You can see that this simple formula leaves a lot out of your true return. It does not account for any value you added to the property for the work you did, appreciation, loan pay down, and tax benefits. In fact, the value of the rental property is not used in the formula anywhere, so there is no real way to know if you are paying a fair price.
Annual Return on Investment: This formula is more sophisticated but it too has its own restrictions. It is harder to calculate and is more speculative. The way I learned how to analyze investments, your ROI includes current value, loan pay down, and appreciation.
Using our same example, let’s assume that the home will be worth $150,000 after you make the $20,000 in upgrades and repairs.
To calculate loan pay down, we have to have a horizon in mind. We need this because every year the loan is paid down more than the year before. Because this is true, if everything else remained the same, the longer you hold a rental property, the better the average annual return will be. This is true up to the point the loan is paid in full. I am going to stick to a 5 year horizon because most investors don’t look further than this. We will need to annualize the pay down to be as accurate as possible. Using an amortization calculator I found online, I plugged in a 30 year, $80,000 loan with a rate of 4.5%. The monthly payment for just interest and principal (no taxes and insurance) is $405. I then pull up the amortization schedule and count out 5 years of payments. The loan amount at the end of 5 years (60 payments) is $72,262 meaning we paid $7,738 toward the loan. Annualize that by dividing by 5 and we get an average loan pay down of $1,548.
Appreciation is an extremely speculative number and there is no way to accurately project this. With that said, I still believe it is important to look at this for an estimated overall return. I try to stay on the conservative side and in a hot market like we are in (often double digit appreciation) I will still use a number closer to the average over a long period of time. I really like to use a range of 5-7% because those are good long term historic appreciation rates. For this example I am going to stick with a 5% appreciation rate. To do this accurately I am going to actually calculate out each year for 5 years to get the 5 year value and then subtract the purchase price. Doing it this way will also account for the additional value we received from doing our $20,000 rehab.
Year Formula Used Value
1 $150,000 * 1.05 $157,500
2 $157,500 * 1.05 $165,375
3 $165,375 * 1.05 $173,644
4 $173,644 * 1.05 $182,326
5 $182,326 * 1.05 $191,442
You can see that we started with the value of $150,000 and not what we actually paid. We multiply the value by 1.05 to add 5% to the previous value. At the end of 5 years, the value is $191,442 or a gain of $71,442. ($191,442 – $100,000 purchase – $20,000 repairs). Again we annualized it by dividing by 5 and get an average of $14,288. Here is a summary of our numbers to calculate our ROI:
- Basis – $120,000 (purchase + repairs)
- Annual cash flow – $5,340 ($445 * 12 months)
- Annual loan pay down – $1,548
- Annual appreciation – $14,288
The formula is the same as COC. Annual return divided by the investment.
($5,340 + $1,548 + $14,288) / $40,000 = 52.94% ROI
Again, I like to look at an investment using both COC and ROI. COC is really important because cash flow is king and it does not include the speculation of appreciation. Cash on Cash might be the most important reason people invest in real estate, it is mine. It can produce cash flow to support you and your family. You cannot spend equity so a lot of the other benefits of real estate are less important in my view. With ROI, although a more accurate look at your overall return, it does not show cash flow. You can literally have a negative cash flow situation and show a positive return with this formula. That is why I like to use both numbers when looking at my returns.
I should point out that I am not accounting for several expenses here. Some obvious ones are closing costs to buy and closing costs to sell. I am intentionally leaving a lot of this out to keep this simple so you can grasp the basic formulas and why I think you should use them both. You can get as complicated as you want and include as much as you can to get the most accurate estimated ROI as possible.
The last thing I want to point out is that neither formula looks at taxes, amount of personal effort or risks. All of that should be considered.