This biweekly sponsored column is written by the experts at Gordon James Realty, a local property management firm that specializes in residential real estate, commercial real estate and home owner associations. Please submit any questions in the comments section or via email.
Real estate investments should be made on their potential to produce a good return (ROI) and consistent cash flow. Experienced real estate investors use financial metrics such as net present value, internal rate of return, and capitalization rate to evaluate real estate investment opportunities.
Net Present Value (NPV)
The net present value (NPV) is a good place to start. The formula provides a broad overview of the value of future earnings in contrast to money invested in the present.
The metric isn’t perfect, but it does give you an idea of whether you’ll gain or lose on a property. Because of that, it’s a good calculation to use when deliberating between a couple of investments. It should always be paired with other financial data before coming to a final decision about a property.
Internal Rate of Return (IRR)
The internal rate of return (IRR) is the discount rate, or interest rate, used to produce an NPV of zero. Generally, the higher the IRR, the better. It means that an investment has less risk associated with it.
However, the IRR calculation, like the NPV, is influenced by cash inflows and outflows, inflation, and other factors throughout the years you hold the property. It should be combined with other financial metrics to develop a clearer picture of your real estate investment portfolio.
The capitalization rate is more often termed “cap rate.” It measures the rate of ROI and is based on the annual net operating income (NOI) of the property. It’s a simple way to calculate potential returns and compare them against current market trends.
Like other calculations, the cap rate has limitations. It only analyzes one year of prospective NOI, a number that doesn’t and often cannot account for expenses like taxes or financing costs. While it’s a good number to have in hand, you should always view it as an exploratory, rather than final, number when evaluating real estate investment opportunities.
Real estate can be highly lucrative. However, it requires careful consideration and an understanding of some basic financial metrics. Always evaluate your real estate investment opportunities’ NPV, IRR, and cap rate before committing to one of them.
In fact, if you’re contemplating a property and would like some advice, we’re happy to help. Not only do we provide residential property management services, but we also counsel clients on their investments.