In real life, there is no secret way to attain real estate investing success. I wish it were not so, but successful real estate investing requires hard work, good research, and a systematic analysis of each and every investment property opportunity.

A proficient real estate professional can help you find, research, and even analyze the profitability of specific rental properties. This can be helpful (even needful), but you want to be prepared. It is good for you to have some knowledge of the rates of return real estate investors generally use during the analysis process before making that all-important decision to purchase a property, regardless.

Since you are new to real estate investing, it seems like a good idea to discuss three of the most commonly used measures and returns.

By themselves, none of these is a deal maker or breaker. You would not make an investment decision based solely on the results of any of these numbers. But they are popular, you will hear them referred to, and it certainly will better prepare you to achieve your investment goal by becoming familiar with them.

Cash on Cash Return

Cash on cash return (C-o-C) measures the initial profitability of a rental property. That is, it indicates the return you can expect to receive in the first year on the money you invest to purchase the property (i.e., the initial cash required to cover your down payment and closing costs).

There are no hard fast rules regarding what return makes a good investment, but it should be obvious that the higher the cash on cash return is the better.

Formula: Cash on Cash = Before Tax Cash Flow / Cash Equity (Initial Investment)

Test your understanding. Given the opportunity to invest $50,000 for a cash-on-cash return of 6.5% or an investment of $75,000 for a 10.2% return, which appears to be the better investment? Though it would require more cash outlay, the higher return, at least on the surface, seems to be the better investment. Why, because a first-year yield of 10.2% on your cash investment is better than a first-year yield of 6.5%.

Gross Rent Multiplier

Gross rent multiplier (GRM) measures the ratio between annual gross rental income and sale price. It is the least informative measure of an income-property primarily because it does not consider a property’s operating expenses, debt service or cash flow, and by itself is insufficient as a stand-alone number because it says nothing about a property’s profitability.

Nonetheless, gross rent multiplier can be helpful for simple comparisons between rental properties. It is an easy calculation you can make in your head, and can be used when you simply want to get some idea how the price for one rental property compares to similar properties recently sold or currently for sale in the market.

Formula: Gross Rent Multiplier = Purchase Price / Gross Rent

Test your understanding. If you are considering a duplex with a gross rent multiplier of 7.2 and know that two similar duplexes down the street sold recently at gross rent multipliers of 8.5 and 9.0, what does that suggest? That you could be getting a good deal, and might want to take a serious look at the property. Why, because the gross rent multiplier on the duplex you are considering indicates a higher ratio of gross rent to purchase price then the market seems to suggest.

Capitalization Rate

Capitalization rate (or Cap Rate) is essentially an indicator of how much debt an income property can carry; the higher the cap rate, the more debt a property can support, and vice versa.

The idea is straightforward. A property’s cap rate indicates the percentage rate of sale price attributable to net operating income (income less operating expenses). That is, it shows how much cash flow is generated to make the mortgage payment as a percent of sale price.

Real estate investors, of course, want to purchase at the highest rate possible (they desire net operating income to be a larger percentage of sale price), while sellers seek to sell at lower cap rates (meaning they can obtain a sale price that is higher compared to the property’s net operating income).

Formula: Capitalization Rate = Net Operating Income / Purchase Price or Value

Test your understanding. You know from your research that small office buildings in your area have typically been selling for a cap rate around 8.3%. The building you are looking at results in a cap rate of 6.8%, what does that say about the price? That unless there are some benefits to prove otherwise, the property might be over priced. Why, because the building in question indicates less net operating income as a percent of sale price compared to what the market suggests.

Conclusion

There is no magic bullet for real estate investing; pure luck is improbable. To succeed, you will have to work hard, research, and above all, do the math. Investment property is all about the numbers, and the more you prepare yourself to run those numbers, the better your chances (as one new to real estate investing) to make money at it.

About the Author

James R Kobzeff is a real estate broker and developer of ProAPOD Real Estate Investment Software – Rental property cash flow, rate of return, and profitability analysis.

Real Estate Investor Software – So those just starting to invest in real estate can determine whether the property makes money before invest.

Mortgage and Financial Calculator – Compute hundreds of mortgage, time value, and cash flow computations in seconds!

Preview an APOD, proforma income statement, and our other cash flow analysis reports at www.proapod.com/ReportsPage.htm

Author: James Kobzeff
Article Source: EzineArticles.com
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