Small residential real estate investors, particularly beginners, often use ROI (Return on Investment) to compare investment deals and discuss their cash-on-cash returns with fellow investors. Undeniably, ROI, with its allure of 10%-20% returns, becomes the main deciding factor for many. However, relying solely on it to compare and make purchasing decisions can lead to dire consequences. This article will dissect this prevalent investment pitfall and introduce a more comprehensive approach to evaluating any potential real estate deal.
Why ROI isn’t good for comparing the deals
vestment considering financial leverage. Utilizing a loan to acquire an investment property is a classic example of leveraging your investment. The degree of leverage is proportional to the loan-to-value (LTV) ratio – the higher the LTV, the greater the leverage. Hence, your ROI can vary significantly based on differing financing costs and leverage ratios, even for the same deal. To put it simply, you can potentially increase your ROI by opting for a higher leverage.
Consider this example: For an investment property valued at $200,000, with a financing interest rate of 4% and a 20% down payment, you can expect an ROI of approximately 15%. However, if you were to reduce your down payment to just 5%, your ROI could escalate to an impressive 24.8%. Remember, we’re still discussing the same property here. Therefore, smart leveraging strategies can enhance your ROI significantly. However, investors should also be mindful of the increased risks associated with higher leverage.
Understanding the reasons why ROI (Return on Investment) may not be the ideal metric for comparing real estate deals requires a firm grasp of what leverage means and how to utilize it strategically. In the realm of real estate investment, leverage refers to the practice of borrowing capital at a lower interest rate to make a higher-return investment.
For instance, imagine an investment property projected to yield a 10% annual return. I could choose to invest my own funds, thereby securing a 10% profit on my initial capital, or I could opt for leverage, borrowing funds at a rate less than 10%. The advantage of leverage lies in its potential to offer theoretically unlimited returns, provided that the costs of financing remain lower than the expected rate of return. Consequently, the trick lies in ensuring a substantial spread between the financing interest rate and the anticipated return. Hence, leveraging in real estate investments, which implies borrowing money at favorable rates to invest in higher-return opportunities, can provide unlimited returns under the right conditions. This is why the simple ROI metric might not be the most accurate measure for comparing property deals. Understanding this concept is crucial to making savvy real estate investment decisions.
While we do not have much control over our financing costs, we can always try to pick the deal that has the best all-cash return (Cap Rate). Then, as a result, it would be the best deal no matter how much leverage we are taking or what’s our financing interests rate.
Cap Rate, Then ROI and DSCR
New real estate investors often find themselves chasing Return on Investment (ROI) without fully grasping the underlying assumptions and potential risks. However, an effective strategy for property investment involves focusing on the Capitalization Rate (Cap Rate) initially. The Cap Rate is essentially the return one would reap if the property was purchased outright with cash, excluding any leverage. By adopting Cap Rate as a core purchase criterion, you’re ensuring that your chosen property is a strong-performing asset.
Once you’ve successfully placed the property under contract and established a baseline for the Cap Rate, it’s then appropriate to consider the level of leverage for that particular deal. Understanding leverage should always involve a thorough assessment of the associated risks. In the real estate sector, the Debt Service Coverage Ratio (DSCR) is a commonly used measure of these risks. Essentially, the DSCR provides a ratio of the expected monthly revenue to the anticipated debt service cost, which typically includes mortgage payments, property tax, and insurance premiums.
If the DSCR ratio barely exceeds 1, it’s indicative of a potentially risky investment. Even a slight decrease in income could tip the balance and lead to negative cash flow. Consequently, a DSCR significantly greater than 1 is usually a safer bet. Given that you’ve already set a baseline for the Cap Rate, and have limited control over loan interest rates, the only element of the DSCR you can effectively manipulate is the leverage ratio, and this can be adjusted through varying the down payment amounts.
Therefore, successful real estate investing isn’t solely about chasing high ROI; it’s about striking a balance between ROI and DSCR to ensure you’re considering both potential returns and the associated risks. Each investor’s tolerance for risk varies, but understanding the trade-off between return and risk is crucial for anyone venturing into property investment.
Conclusion, also TLDR version
While scanning the market and trying to find a good deal to buy, investors should use the cap rate for comparing deals. After the property has become under contract, investors should understand the trade-off between return and risk and choose the strategy that’s the best suited for them. For risk-seeking investors who are looking to expand their portfolio quickly, they can go with a lower down payment, which would result in a better ROI (better cash-on-cash return) but DSCR closer to 1(riskier). For risk-averse investors who are looking for good cash flow and less management overhead, a bigger down payment, results in a relatively lower, but still good ROI and higher DSCR. To calculate the Cap Rate, ROI, Cash Flow, and DSCR, investors can use PortfolioBay’s free deal calculator to get a quick estimate and be confident in making sound investment decisions.
