How to Measure Return on Investment (ROI) Before I Buy or Exchange

Return on Investment or ROI is a performance measure used to evaluate the financial return on investment property. To calculate ROI, the return of investment is divided by the cost of the investment.  The result is expressed as a percentage, or a ratio.

Many Investors and banks determine this ratio by using various indicators.  One method is the Capitalization Rate (also known as the CAP Rate).  The CAP rate is calculated without considering the debt.  Determining the return on an investment before the debt isolates the merits of the investment on its own. 

A second useful metric is to determine the Cash on Cash percentage return on the investment’s down payment.

A third method is to determine the Gross Rent Multiplier (GRM).  The GRM is not a very precise tool for ascertaining value. However, it is an excellent first quick value assessment tool to see if further, more detailed analysis can be warranted. If the GRM is too high or low compared to recent comparable sold properties, it may indicate a problem with the property or gross over-pricing.

The following are simplified formulas in determining the CAP rate, the Cash on Cash return, and the Gross Rent Multiplier: 

First, determine the Net Operating Income or N O I
(Gross Annual Income – Annual Expenses)

1. Total all scheduled gross Annual Income of the building.
2. Total all Annual Expenses including: Taxes, Insurance, Utilities, Trash, Landscaping, Professional fees, Management fees, any annual Maintenance fees, etc. Do not include debt expenses.
3. Subtract Annual Expenses from the Gross Annual Income. 

The result is the Net Operating Income of a property.

C A P  Rate   (NOI  Sales Price)
Divide the NOI by the Sales Price.
This provides the Capitalization Rate of a property.

Cash On Cash Return   (Cash Flow  Down Payment)

1. Estimate the Annual Income of a property.
2. Subtract all Annual Expenses and Loan Payments.
3. This totals your Annual Net Cash Flow.
4. Divide the Annual Cash Flow (#3) by the Down Payment.

The percentage is the Cash on Cash return is on your down payment.

Gross Rent Multiplier   (Market Value   Annual Gross Income)
The asking price of the property divided by the Annual Gross Income.

Things to Consider:
The higher the CAP Rate, the greater the cash flow.  Your goal should be to locate properties with higher CAP Rates.

• Seasoned buyers look for properties where rents can be raised, thus creating greater cash flow.
• The condition and location of the investment.
• The ability of the property to appreciate in time.
• A new or adjusted Depreciation schedule to help shelter income.

We highly recommend that you consult with a Real Estate and Tax professionals to help you determine if a particular property makes sense for you.