Start from day one thinking of yourself as a business owner. Like any industry, it has it's own lingo. I'm going to talk you through the terms that matter. Because they do.
- ROE: "Return on equity"
- CAP rate: "Capitalization rate"
- NOI: "Net operating income"
And then there's cash flow and cash-on-cash. Acronym-less.
Return on equity is how hard the dollars you invest in real estate is working for you. You should aim for roughly 10%+ ROE even from year one. Every investment area, every person, every property is different. I'm just telling you what I shoot for as a minimum.
It is a percentage. It is how much profit (return) your investment real estate generate for every dollar you invested (equity) usually your downpayment.
ROE is useful because you can compare investing your dollars across different asset classes (like stocks or bonds or gold or bitcoint or whatever).
ROE helps you understand the returns of a specific property for you relative to your other investment opportunities
ROE is specific to you. Your ROE for property A will be different to your best friend's ROE for the same property. Your mortgage rate might be slightly different. You might put 30% as a down payment vs your friend's 20%. You might upgrade the bathrooms to charge more rent. Your decisions and your circumstances affect your ROE.
ROE is NOT how much cash you have at the end of the year. Why? There's a 99% chance you're getting a mortgage from a bank. Your repayment to the bank is the interest of the loan and some portion of loan itself (the principal). The interest portion is a cost to you. The bank charges you interest. This eats into your returns and lowers the 'R' bit of ROE. The principle portion does not eat into your returns. But it does eat into your cash flow, because you have to give the principal bit to the bank. That's why ROE and cash flow aren't the same.
Does ROE include the value of the property going up? Does it include depreciation write-off? (More on this last piece elsewhere).
Not in my book. It's too hard to know how much your property has gone up by in a year or even two. And - let's be honest - values can come down also.
Net operating income is the rent you charge less any costs running the property you pay. It does not include financing, depreciation, taxes etc.
You own a rental property. You charge rent for the unit, for parking, and for a storage locker. That's all your income. You net (subtract) all the stuff you as the owner have to pay for. Property tax. Your landscaper. Water and sewage bills. Electricity bills. Your property manager. Repairing the gutter. Your bookkeeper's time. And so on. In simple terms, all your bills.
To repeat, it doesn't include your mortgage, any depreciation your accountant includes, your taxes.
NOI is basically the same for everyone. Anyone who owns property X will have pretty much the same bills to pay. The main difference will be your property manager costs. One reason why it is so important to negotiate the property management fees in advance.
Figure out what your NOI is for a property. Don't just take the sellers sheet at face value. Get the real rents and the real expenses for the last two years.
Capitalization rate is everywhere in real estate investing. Why? Because unlike ROE, it isn't specific to you.
CAP rate allows you - and everyone else - to compare any two properties for their hypothetical returns. Below 5% is usually cash flow negative for most investors.
Hypothetical. You shouldn't like the sound of that. I don't.
CAP rate is the returns of a property if you didn't have to finance it. That works if you're the heir to an oil empire. The reality is that 99% of us need a loan. That's why it's a hypothetical. If you paid $500,000 cash for a property and it made an NOI of $50,000 then the CAP rate is 10% ($50K divided by $500K). No financing included. No property management included.
CAP rate is the NOI divided by the purchase price. As you saw above, NOI is pretty much the same for everyone.
You'll typically see CAP rates of 4% to 7%. They're a starting point and that's it. Create your own rental calculator because the CAP rate doesn't mean anything for your situation. You have to include your real costs. That's property management and financing and anything else.
Cash flow and cash-on-cash
Be. Cash flow. Positive.
Cash flow is how much cash flows in and out of your bank account at any time.
Once you've bought your rental property with your downpayment, you shouldn't need to sink another dollar into it. The property should build enough cash over time to finance renovations. Or to cover unexpected vacancy.
Cash flow is king. Simple. Forecast your cash flow.
You may have a different circumstance. You may be comfortable with heavily financing a property so it is profitable but still requires you to inject cash. Fine.
For the rest of us I'm not going to beat around the bush. Get a place that kicks off enough cash. You'll have peace of mind. You'll be able to buy other places with this cash (hopefully!). If you're sinking more dollars into a place (it's cash flow negative) you're really hoping for the place to go up in value or rents to rise disproportionately quickly. You're taking on more risk is the upshot.
You will rarely hear the phrase cash-on-cash. Don't confuse it with ROE.
Cash-on-cash is how much cash your property puts in your bank per dollar of down payment. You put a down payment of $100,000. At the end of your first year you have $20,000 more dollars in your bank account than you did at the start. $20,000 divided by $100,000 is 20% cash-on-cash return.
All four metrics have their use. None is right, none is wrong. It's like car performance. Acceleration, top speed, fuel efficiency, tank range all have their uses. They're all connected and together paint a picture of how good the car is for you.
ROE ("return on equity") allows you to compare a property against your other investment opportunities. Aim for 10%+ as a guide.
NOI ("net operating income") are the raw dollars made on a property. They're a little different for everyone for a given property.
CAP rate ("capitalization rate") is the most standard way of comparing the returns of different properties irrespective of your circumstances. Aim for 6%+ as a guide.
Cash flow is the hard dollars moving into your bank account for a given property you own. Be cash flow positive.