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Additional Real Estate Profitability Metrics
The cost and out-of-pocket methods can paint a general picture of how beneficial a rental or investment property will be. However, if you want more detailed metrics that pertain to different aspects of a property, use the formulas below to enhance your ROI projections.
Capitalization Rate (Cap Rate)
Cap rate, or capitalization rate, is the third most popular way to determine real estate return on investment. Cap rate estimates rental property profitability in total – regardless of the financing method used. When comparing investment properties, it’s common to use cap rate for a straightforward glance at ROI.
Capitalization Rate Formula: (NOI / Property Value) x 100% = ROI
For example, an investor is looking to buy a property to rent out that’s valued at $300,000. After subtracting operating expenses from total revenue, the net operating income (NOI) for said property is $30,000.
Capitalization Rate: ($30,000 / $300,000) x 100% = 10% ROI
Cash on Cash Returns (CoC)
Cash on cash returns (CoC) accounts for the total amount of invested cash into the real estate return on investment formula. In relation to the standard ROI formula mentioned above, CoC returns replace expenses and rental income with annual pre-tax cash flow.
Cash on Cash Return: (Annual Before Tax Cash-Flow / Total Invested) = ROI
For example, a $500,000 single-family home was purchased with $200,000 of invested cash and generates $50,000 in pre-tax cash flow each year, resulting in a 10% real estate return on investment.
Cash on Cash Return: ($50,000 / $500,000) x 100% = 10% ROI
Gross Rent Multiplier (GRM)
The gross rent multiplier is another method for measuring the profitability of an income producing property. The GRM of a property expresses how it compares in rental income compared to properties similar in value. Note here that GRM is most useful when comparing two or more properties.
Gross Rent Multiplier: (Property Value / Gross Rental Income) = ROI
Say, for instance, an investor is looking at buying investment property in two different neighborhoods. In the first neighborhood, there’s a property for sale valued at $300,000 and collects $50,000 in rent annually. In the second neighborhood, a similar property is valued at $250,000, and collects $45,000 in rent per year. Which property, then, will be most profitable?
Gross Rent Multiplier:
- Property 1: ($300,000 / $50,000) = 6
- Property 2: ($250,000 / $45,000) = 5.5
The lower the GRM, the higher your potential profits. In this instance, the property in the second neighborhood would give you a higher real estate return on investment based solely on rental income.
Average ROI on Real Estate
The average annual return over the past two decades from residential and commercial real estate is approximately 10%. The S&P 500 Real Estate Index measures national average real estate return on investment, and includes a number of real estate investments like single-family homes, apartments, and commercial buildings – to name a few.
Real estate return on investment depends on the kind of property being purchased. See the difference between the average rental property return against the average real estate return below:
Average rental property return: 10.6%
Average commercial real estate ROI: 9.5%
Many investors aim to match or exceed these average return rates when buying investment property.
Real Estate vs. Stocks Historical Returns
Investing in real estate doesn’t necessarily mean purchasing a physical property. Real estate investment trusts (REITs) that trade like stocks can provide investors with a further diversified portfolio. The chart below compares real estate vs. stocks historical returns via the Vanguard’s Real Estate ETF and SPDR® S&P 500 ETF Trust.
| Historical Real Estate Returns | Historical Stock Returns | |
|---|---|---|
| 2021 | 28.59% |
40.38% |
| 2020 | 18.25% |
-4.72% |
| 2019 | 31.29% |
28.91% |
| 2018 | -4.45% |
-5.95% |
| 2017 | 21.69% |
4.95% |
| 2016 | 11.80% |
8.53% |
Real estate vs. stocks returns is the million-dollar debate that investors are consistently mulling over. Ultimately, choosing between the two will depend on your risk tolerance and personal preference.
Knowing exactly how to calculate real estate return on investment is no simple feat. There are many factors involved in becoming a successful investor with strong monthly cash flow in the real estate market. If you’re new to investing, the best thing you can do is find a real estate partner or mentor that can help you develop the skills and knowledge to be successful.
If you’re ready to get started on your next project, contact us today and benefit from our 40+ years of experience in the industry.
