How to calculate the viability of investing in Real Estate
In order to choose between investing in Real Estate relative to another investment, we will use several indicators and estimates.
Before using these estimates, we need to calculate expenses and income.
Calculation of purchase expenses
The cost of purchase
In most cases the main cost of investing in Real Estate is the property purchase price. The calculation of the purchase price must include not only the amount that is handed over to the seller but also the costs of the realtor, the lawyer, the fees, the cost of registering the property in your name and of course taxes.
We will start with the annual rent (multiply the monthly rent by 12).
From the monthly rent we need to reduce:
Periods when the property will stand vacant
Regarding the vacancy periods, one must calculate not only the rent that will not be received, but also costs that the owner will bear during the period when the property will be empty, that usually will be paid by the tenant for example insurance.
Costs when re-renting a property
Costs for advertising, brokerage and travel expenses need to be considered if we need to travel to the property in the rental process.
It is assumed that every year we will spend between 0.025% and 3% of the value of the property on maintaining the property. It depends on the age of the property, whether it has undergone a significant renovation recently (significant renovation includes renovation of water and electricity systems) and the nature of the tenants. Bear in mind that in a property located in a shared building, public maintenance expenses are to be expected, some of which will be charged to the owner such as elevator repairs, roof sealing, etc.
Estimating the viability of the investment
Estimates of current return
After we have calculated the full current income and expenses, we will receive the Net Operating Income (NOI) which is the current income minus the current expenses.
Sometimes investors refer to the “return” on the property as the rent divided by the purchase price. This is a mistake. The correct return is called the Cap Rate (short for Capitalization Rate). We calculate it as follows:
Cash on Cash Return
So far, we have not considered two significant issues: taxes (on income and capital gains) and financing.
In most countries there is a tax for renting properties. In most cases if you take a mortgage you will be able to deduct the interest paid on the mortgage from your earning for tax purposes.
In many cases your returns will be higher if you will take a loan to finance your investment. If a loan is needed then we need to take into account that it reduces the initial payment but on the other hand the repayments will reduce the cash flow received from the property.
After weighting up the taxes and money for the debt service (principal repayments + interest) we can calculate the estimate:
So far, we have calculated the return without taking into consideration the selling the property in the future. We will now include future gain from the sale.
The calculation of the return includes the profit from the sale
In order to enhance the sale price, we must take into account the period for which we will hold the property until its sold.
Even if there is no exact timeframe for how long we will own the property and we think we might even keep it and give it the kids, it’s important to assume that it will be for some period of time.
Think you’ll hold on to it forever? Excellent, let’s just say you keep it for 15 years.
We will start by predicting the price at which we will sell the property. It is recommended to calculate both methods below in order to test the plausibility of the results.
Calculation of the future price according to the expected annual increase in property prices.
Purchase price – 1 million
NOI – 50,000
That means we bought it at a cap rate of:
In addition, we will assume that we will hold the property for 15 years and the price of the property will increase by 1% per year and the rent (and with them the NOI) will increase by 1% per year.
First method – according to the expected annual increase in the price of the assets
We will take the original price we pay to the seller (excluding taxes and additional costs), and the expected increase in property prices and enhance it with compound interest.
If, for example, it is a property worth 1 million and we assume that the price of the property will increase by one percent per year and we will hold it for 15 years, then the price in 15 years will be:
The second method according to the future Cap Rate
Assume that the cap rate, i.e. the return according to which they will buy the property for sale, will be 5%, we assume that the rent will increase by 1% a year, so in 15 years it will be 58,000. The price at which we will sell the property will be as follows:
In the example, I forced a connection between the two methods, in reality there is likely to be a difference between them. Too big a difference means that our assumptions must be carefully examined.
Now that we have the expected price at the sale it is possible to use some methods to assess the viability of the investment.
First method – IRR – Internal Rate of Return
The IRR is excellent for comparing the profit we expect to make in comparison to other investment channels, for example bonds.
Suppose we estimate that the IRR of the project is 8%. How do we know this is a high enough return?
Let’s examine this according to the alternatives. The most important alternative is the risk-free return. That is, the yield of the government bond in the country in which we wish to invest. To the bond yield we add a risk premium, which expresses our investment risk. If the IRR of our investment is lower than this number, it is not a good investment.
Second method – the investment multiplier
* Including tax deductions and loan repayments
Sometimes this indicator is called – X
For example, when you read the brochure where it says that the profit is X1.6, which means that for every one USD you invested, you get 1.6 USD back.
The weakness of this estimator is that it does not take into consideration the period and repayment structure, but for comparing investments with similar time frames, in most cases it is good enough.