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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 [1] 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 [2] 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.

More Formulas

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 [3] 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 [4] and the vacation rental [5].

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 [6]. 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?