Return on investment on rental properties, is a calculation which measures the profit a real estate investment will generate. It is then compared to the amount of capital initially invested, to give a percentage yield on an annual basis. As a simple example consider the following -- a fully occupied commercial plaza sells for $500,000 with a net operating income (NOI) of $50,000. Based on an all cash purchase, the (ROI) is 10%. Not bad in today’s low interest rate environment.
But consider the effect of arranging a 1st mortgage on the purchase of $350,000. Again for illustration purposes - let’s assume a mortgage rate of 5.5% and an amortization of 20 years. Going back to our plaza purchase above, annual mortgage costs amount to $28,740/year, leaving a net income (after debt service) of $21,260. The yield now on the cash invested, is + 14.2% ($28740/$150,000). Welcome to the world of LEVERAGE!
In the case of part 2 of our example (after arranging a mortgage for the purchase), we can actually increase the rate of return on our cash invested by 4.2%. In essence, we are increasing our yield through the use of borrowed money. With this analysis, we are only looking at the existing cashflow (rental stream), which the property provides. We’ll take a further look at ‘leverage’ in future blogs, as we factor in price appreciation/growth and other strategies.
Just a further comment on the initial cash investment (beyond the actual downpayment) - be sure to include closing costs, land transfer tax, immediate capital improvement expenses etc. Essentially calculate the total estimate of your upfront cash requirement to take on the property.
Next up…sifting through the financial data and ensuring its accurancy & reliability. Again, seek out experienced commercial realtors within your market to assist in searching out quality rental properties to invest in.
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