ROI as a Function of the CAP Rate, Mortgage Interest and your Down Payment

[Nir]

Hi All,
I wanted to share a formula I developed with you to help make real estate investment decisions. It`s your ROI as a function of the CAP Rate, mortgage interest and your down payment:

ROI = [(CAP-i)/d] + i

ROI - Return on investment including mortgage principal paid not including any appreciation.

CAP (CAP Rate) - Ratio between cash flow and purchase price(%). Interest expenses are excluded, in other words CAP rate does not depend on the amount of debt used to purchase the property

i – mortgage interest (%)

d – down payment (%)

The formula shows how a positive ROI depends on the CAP rate being higher than the mortgage interest. ROI is sensitive to changes in mortgage interest and while I prefer variable rate, a CAP rate too close to your interest is a sign of low cash flow or risk of negative cash flow. From the formula you can also see how putting down half the amount you intended to, almost doubles your ROI(!) (not considering mortgage insurance premium however)

Regards,
Neil

 

[RedlineBrett]

I would caution against using cap rate economics for anything with less than four doors.
I use an annualized rate-of-return metric as my `tell all benchmark` to help me choose between one deal or another.

While my formulas are pretty complicated (they include a full amortization table allowing you to accurately capture principle paydown at any time interval you want while also taking into consideration the time value of money of an expense or cash flow x number of years from now) the process can be boiled down to two very simple formulas:


ROR = (total profit/capital invested)

Where ROR is total return
total profit is future value - present value
capital invested is all the money you have put into the property

Annualized ROR = (ROR+1)^(1/n)-1 where n is the number of years out that you have computed your ROR

This gives an annual return that can be compared against more traditional investment vehicles (GICs, mutuals, S&P 500 etc)

The trick is using the least cash possible while still cashflowing OR having a big enough capital reserve to fund a dog for the first few years that you can get into for very little cash.

QUOTE (investmart @ Apr 14 2008, 11:21 PM) Hi All,

I wanted to share a formula I developed with you to help make real estate investment decisions. It`s your ROI as a function of the CAP Rate, mortgage interest and your down payment:

ROI = [(CAP-i)/d] + i

ROI - Return on investment including mortgage principal paid not including any appreciation.

CAP (CAP Rate) - Ratio between cash flow and purchase price(%). Interest expenses are excluded, in other words CAP rate does not depend on the amount of debt used to purchase the property

i – mortgage interest (%)

d – down payment (%)

The formula shows how a positive ROI depends on the CAP rate being higher than the mortgage interest. ROI is sensitive to changes in mortgage interest and while I prefer variable rate, a CAP rate too close to your interest is a sign of low cash flow or risk of negative cash flow. From the formula you can also see how putting down half the amount you intended to, almost doubles your ROI(!) (not considering mortgage insurance premium however)

Regards,
Neil

 

[Nir]

Thanks Brett, great input!

What I like about the formula ROI = [(CAP-i)/d] + i is that it is simple. It`s true that the ROI is a "moving target" due to the change in the amount of principal paid from year to year. However, if you do the math you`ll see this formula is not only simply and easy to understand but also a very good estimate of the ROI in the FIRST years and an accurate one in the first year.

Regards,
Neil

 

[blissedheart]

hi there,
please can you both show examples of how this formula actully computes with a value of a property at 100,000.
i am not too sure of the symbol "^".
mant thanks
blissedheart

 

[Nir]

Example for ROI = [(CAP-i)/d] + i

Property purchase price $100,000
Mortgage interest (i) = 5%
Downpayment (d) = $10,000 =10%
Cap rate (CAP) = 7%

ROI = [(CAP-i)/d] + i = [(0.07-0.05)/0.1] + 0.05 = 0.25 or 25%

 

[RedlineBrett]

PV (present value) = $100,000
FV (future value) = $100,000 x (1+i)^n (i is appreciation rate, I use 6%/yr) n is time in years (I use 5) the `^` symbol means "to the power of", or exponent. Remember your algebra and do the 1+i first and THEN the exponent, and THEN times by 100k

so FV = $100,000 x (1+0.06)^5 = $133,822.56

ROR = (total profit / capital invested).

Total profit = future value - present value. Lets say the property was in perfect condition but you had $2500 in closing costs and inspections and other misc. costs incurred when buying (costs of entry). Let`s also say you put 25% down.

Cash down = 0.25 * PV = 0.25 * $100,000 = $25,000

Costs = $2500. (If you are renovating or adding value to your property to get it ready for tenants I will usually add this back to the present value $ for $. In this case we`re not because closing costs add no value).

Capital invested = Cash down + costs = 25000 + 2500 = $27,500.00 (this is the CASH or equity YOU are investing in the property. Remember you are using the banks money for the other $75,000

total profit = $133,882.56 - $100,000 = $33,882.56 (this is assuming breakeven cash flow for five years and no fees at sale etc)

ROR = ($33,882.56/$27,500) = 1.2321 or 123.21%

Annualized ROR = (ROR+1)^(1/n) - 1
= (1.2321+1)^(1/5)-1 = 17.42%/yr on your money

(CHECK 27,500 * 1.1742^5 = 61382 - 27500 = total profit of 33882.56 )










QUOTE (investmart @ Apr 16 2008, 12:16 AM) Thanks Brett, great input!

What I like about the formula ROI = [(CAP-i)/d] + i is that it is simple. It`s true that the ROI is a "moving target" due to the change in the amount of principal paid from year to year. However, if you do the math you`ll see this formula is not only simply and easy to understand but also a very good estimate of the ROI in the FIRST years and an accurate one in the first year.

Regards,
Neil

 

[blissedheart]

hi there,
i really value both ofyou showing me this equation in detail.
it really adds to my collection of equations and another way to look at the future.
thank you both for your timely response.

where else can i finfd other formulai that would help with anything?
thanks
blissedheart

 

[joeiannuzzi]

If you are looking for more formulas, you may wish to purchase the book "What every real estate investor needs to know about CASH FLOW..... and 36 other key financial measures" By Frank Gallinelli.

Here is a link which summarizes the chapters of the book.

http://wikisummaries.org/What_Every_Real_E...ancial_Measures