How to Calculate Real Estate Investment Returns
What was the return on our real estate investments?
As I update all of our investments for year end (it takes me until April, because many of our accounts don’t send year end statements until then), I like to compare our investment returns.
The stocks and index funds are easy, as Quicken computes the IRR. But I like to be able to compare our other investments too, like our real estate.
Unfortunately, it seems as if there are so many formulas to evaluate real estate returns, (ROI, ROE, Cash on cash, etc) pinpointing just one to use as a comparison is difficult. And everywhere I look, I find differing opinions on which formula to use. So, I’m going to work through multiple formulas:
Return on Equity
First up is return on equity. The return on equity formula I’m using is the ROE for properties beyond the first year of ownership:
ROE = Cash Flow After Taxes (CFAT) / (Property Value – Mortgage Balance)
For the first real estate investment we purchased (the house), I get this for 2011:
ROE = $1705 / ($248162 – $200926)
For the property value, I use the estimated fair market value on our tax bill, less the cost to sell the property.
The cash flow before taxes for this property was -$56 this year, but the -$5680 tax bill at 31% brought the CFAT up to $1705.
If the property was in the first year, you can divide by the initial investment in the property.
ROE = 3.61%
Another Return on Equity
However, it seems like the first ROE calculation is ignoring the change in equity from the prior year in the denominator, which I think actually should be part of the return. The principal is reducing, and the value is increasing (hopefully), without any additional contributions from us.
So, I calculated ROE method 2 for last year:
ROE(2) = CFAT + Principal Reduction + Appreciation / (Property Value Last Year – Mortgage Balance Last Year)
ROE(2) = $1705 + $2866 – $658 / ($248820 – $203792)
ROE(2) = 8.69%
Internal Rate of Return
So that brings me to internal rate of return (IRR). If I calculate the IRR for 2011 in isolation, using the following calculation in excel:
- -$45028 on 12/31/2010 (equity at beginning of year)
- $1705 on 12/31/2011 (CFAT)
- $47236 on 12/31/2011 (equity at end of year)
In excel, my formula looks like =XIRR(A1:A3,B1:B3). The amounts are in the first three cells in column A and the dates are in the first three cells in column B.
XIRR = 8.69%
The IRR matches the ROE(2), but only because I lumped the cash flow into one payment at the end of the year.
If you are working through the same exercise for your real estate, the other calculations I used to begin are:
- Cash Flow Before Tax (CFBT) = Net Operating Income (NOI) – Debt Service – Capital Improvements + New Loan Amounts + Bank Interest Earned
- Cash Flow After Tax (CFAT) = CFBT – Income Tax
- NOI = Income – Operating Expenses
- Debt Service = Principal and Interest Payments
Here are my numbers I used in the formulas if you are following along at home:
CFBT = $14716 – $14772 – $0 + $0 + $0
CFBT = -$56
Income Tax = -$5680 X 31%
Income Tax = -$1761
NOI = $32356 – $17640
NOI = $14716
When you calculate the returns for each of your properties using the formulas above, what did you get?
Note: I ran all of these calculations at our partnership level, and didn’t factor in my use of credit card balance transfers which covered some of my personal equity in the properties, and provided additional leverage. I wanted to start with the basic calculations first before I make them over complicated!
Our Other Real Estate
I ran the same calculations for our other real estate, the condo and the vacation rental.
The condo has a better ROE(1) at 4.01%, but a negative ROE(2) and IRR at -16.02% last year, largely because the fair market value of the property went down. I also calculated the IRR since we bought it: 37.7%. Because it was bought at an auction, most of the equity that we have is from appreciation in the first year, which makes the total IRR much higher. The IRR since we purchased the house is 1.3%
The vacation rental on the other hand breaks the calculation, with the negative cash flow, and the impact of the vacation home tax rules. I’m still trying to find a way that we’ll be able to compare that one in the same way after removing the impact of our personal use.
What is My Return?
I’m still trying to figure out if I can really use either the ROE(2) or the IRR to compare to our other investments. Is there a better way to compare on an apples to apples basis?
I know that some of you are heavily involved in real estate investments, so I’d like to hear from you! What do you think of my approach? Feel free to offer another way to evaluate the return. I tried to include all of my numbers for you to play with!
How do you calculate the return on your real estate investments? And how do you compare it to your stocks?
I have to disagree with your methods on determining your rate of return (each method). There are a couple of assumptions that you make which make for your numbers to be a bit off. A rate of return for an investment is basically how much you have benefited, minus your costs. First off, the loan principal is the amount that is owed on the loan. That changes monthly, and should be reflected in your profit an loss. Secondly, the money you have invested (your mortgage down payment) has a cost, and that money could be earning profit elsewhere (I use 8%).
As part of the Revenue section, I think it is a bit simplistic to times everything by your highest tax rate. To determine the exact value, you should figure your taxes with, and without those numbers. An example for me is when I look at my rental, I hit the tax maximums, and cannot claim anymore for the tax and mortgage deduction. Plus if I remove my property, it is better for me to take the standard deduction, versus the itemized deduction. I don’t know your situation, but I would saying multiplying by your highest rate might be the most accurate number. Finally, when calculating the value of your home, you should rely on the experts at your tax assessment office (I am not saying they are experts, just better than almost anyone else), just that it is a number that you should be within 10% of what to expect for your home sale. If it is higher, great, then you get more profit when you sell. If it is less, then the government is not that good at its job. Here in Indiana, the assessed value is rather close to the value of our homes, and don’t change that much year over year as it should be.
I figured this formula for a rent to own situation I am doing. This should work for anyone truly trying to figure their profit/loss on a property.
Loan Principal (changes monthly) + Downpayment (converted to NPV) + Tax Payments in the Year + Mortgage Payments + Insurance Paid (converted to NPV) + Maintenance & other expenses (converted to NPV) = Costs
Rent Received + Tax reduction due to property tax + Tax reduction due to mortgage interest + Assessed value of the home = Revenue
Then take the Revenue – Costs = Profit. If this is a multi year investment, minus the Profit value from 12/31/2010 (assuming a 2011 year investment). You can divide the Profit by the Costs if you want a %.
Big-D’s formula is more complex than what I use, but many of his points are valid. I basically use (free cash thrown off by the investment)/(cost to get into the investment)
I think that using any of the tax reductions in calculating your return is cheating – and you are also not accounting for the reduction in basis when you go to sell the property. You WILL have depreciation recapture when you go to sell which will impact the real equity in the property.
Going back to the formula, I really only calculate it yearly, but:
Cash = reduction in principal + (cash remaining after all expenses associated with the property are paid)
That is pretty close to your CFBT, but some people try to cheat and say things like legal expenses are not operating expenses.
Here’s an example: Let’s say that I bought a property 3 years ago and put $100K down on a $400K value property. This year, I take the total rents and then subtract off every single expense associated with the property. It’s not pure “cash flow” because I also count the reduction in principal. Any cash left over plus the reduction in principal divided by the 100K I put into the property I consider my rate of return.
I don’t usually track the appraised value of the property – and assessor values are pretty much fantasies. You also really don’t know what you are going to get as an offer on the property once you put it on the market – and the transaction cost can be large.
For your house #1, it looks like you put down 32K, paid down $2866 and had cash flow of -56. That gives you 2810/32K = 8.7%, which is not a bad year.
One thing to notice here is that your projected cash flows really didn’t work out.
You thought that you would be cash flowing, but you are not. That’s not the end of the world, but learn to increase your vacancy loss or repairs estimate or whatever is not coming out right so that you can bid more accurately on future properties.
Another thing that I note is whether you have refinanced? For your first property, if you are still at a 5.875 3/1 ARM, there are better rates out there and that could really help your cash flow situation.
Also, you are having a similar experience with vacation homes – they are usually pretty tough to make work.
Anyway, congratulations on doing as well as you did on house #1! You are really not in a bad situation there – much better than most people who are first entering the game!
I haven’t done much in real estate so will have to research further.