Below, we’ll look at three methods of calculating returns on short-term rentals to help you make informed investment decisions.
First, we’ll look at cap rates. A cap rate is a simple metric that expresses a property’s net operating income (NOI) as a percentage of its purchase price. Put another way, the cap rate tells you how much income the property generates relative to the cost to purchase the property.
As a refresher, here’s how to find NOI:
NOI = Annual Total Revenue - Annual Operating Expenses (Not Including Loan Payments or Taxes)
*When calculating cap rates, we use annual NOI; that is, the property’s net operating income for one year. Therefore, you need to plug in annual total revenue and annual operating expenses to get the right answer.
Once you know your NOI, you can find the cap rate with the following formula:
Cap Rate = Net Operating Income (NOI) / Purchase Price
Let’s look at a simple example:
Net Operating Income: $40,500
Purchase Price: $900,000
If we run these numbers through the formula, we get:
Cap Rate = $40,500 / $900,000 = 4.5%
Cap rates vary with location, and what is considered high in one area might be regarded as low in another. Cap rates are often used by investors to compare potential investments to recently sold properties in the same market. By calculating cap rates for recent sales in a certain market, you can figure out what you should pay for a property based on its NOI.
The next method we’ll look at is cash-on-cash return. Cash-on-cash return tells you how much cash flows out of an investment relative to how much cash is put in.
First, we need to find the annual cash flow:
Annual Cash Flow (Pre–Tax) = Total Revenue - (Operating Expenses + Financing Expenses)
*Note that the formula for cash flow is similar to the formula for NOI but also includes financing expenses. “Financing expenses” are what must be paid in a year to service a loan — 12 months of loan payments.
Next, we need to calculate the amount invested. You can think of this as the total cash required to purchase the property and get it running. The bulk of this will be the purchase price of the property (if paying cash) or the down payment (if using a loan). You’ll also include any closing costs (realtor commissions, mortgage fees, title insurance, inspections, etc.) and renovations or repairs that must be paid for before the property can be rented. Real estate taxes are not included, nor are monthly loan payments. Once you’ve found all of these individual costs, add them together.
Finally, we can find cash-on-cash return using the following formula:
Cash–on–Cash Return = Annual Cash Flow (Pre–Tax) / Amount Invested
Let’s work through a simple example:
Amount Invested: $1,000,000
Annual Cash Flow (Pre-Tax): $50,000
Plugging these numbers into our formula, we get:
Cash–on–Cash Return = $50,000 / $1,000,000 = 5%
A 5% cash-on-cash return means that you receive 5% annually for every dollar you invest. If you invest one dollar, you receive five cents per year. If you invest $1,000,000, you receive $50,000 per year.
You might have noticed that the formulas for cap rate and cash-on-cash return look similar. The key difference between the two is that cash-on-cash return accounts for the effects of using a loan, while the cap rate does not. Let’s look at an additional example that highlights how loans can magnify your cash-on-cash return [LINK: Short-Term Rentals: Loans]. For the sake of simplicity, we will leave out closing costs and renovations for now.
Purchase Price: $1,000,000
Down Payment: 20%
Amount Invested: $1,000,000 * 20% = $200,000
Annual Cash Flow (Pre-Tax, Before Loan Payments): $50,000
Annual Loan Payments: $30,000
Annual Cash Flow (Less Loan Payments): $50,000 - $30,000 = $20,000
Cash–on–Cash Return = $20,000 / $200,000 = 10%
The deal itself hasn’t changed — we’re still dealing with a $1,000,000 property that produces $50,000 in pre-tax cash flow annually. By adding a loan with a 20% down payment and annual loan payments of $30,000, we reduce the amount invested by 80% and the cash flow by 60%. Plug the new values into the cash-on-cash return formula, and you can see that by using a loan for this deal, we’ve doubled our cash-on-cash return.
Investors typically look for a cash-on-cash return between 7–12%, but there’s more to evaluating an investment than just this one metric. Some investors might find a low cash-on-cash return acceptable if offset by significant market appreciation.
IRR, or Internal Rate of Return, is a more complicated metric than cash-on-cash return or cap rate. You can’t calculate IRR by hand or with a regular calculator — you’ll need Excel. But don’t let that scare you off — if you know how to use it, IRR is one of the most valuable metrics available to short-term rental investors. Of the three metrics we’ve looked at, this is the only one that accounts for the effects of appreciation.
The previous two methods, cash-on-cash return and cap rate, offer a snapshot view of an investment — the investment’s performance at a single moment in time. IRR is different in that it looks at a series of anticipated cash flows over the life of an investment and gives a single rate that represents the investment’s total return over time. IRR considers the purchase price, multiple cash flows, the sale price, and the time value of money (a dollar today is worth more than a dollar tomorrow).
The set of estimated cash flows that you plug into Excel to calculate an IRR might look something like this:
Year 0: -$250,000 (Purchase Price, Startup Costs, Repairs)
Year 1: $20,000
Year 2: $22,000
Year 3: $24,000
Year 4: $26,000
Year 5: $375,000 (Sale Price of $347,000, plus Year 5 cash flow of $28,000)
If you run Excel’s IRR formula, you’d find that this investment has an IRR of 15%.
If all else is held equal, the investment with the highest IRR is the best choice. Though, in the real world, a sky-high IRR may indicate elevated levels of risk. The highest IRRs are usually found alongside deals that carry greater risk, like development or value-add deals.
One caveat; IRR relies heavily on forecasting future cash flows, which is not the easiest thing to do. Experienced investors usually model a few different scenarios; an optimistic case, a pessimistic case, and a most likely case.
The best way to learn how these metrics work is to use them. With hands-on experience, you’ll gain a gut feel for how the numbers work. Don’t worry if you can’t figure some of these out — answers and explanations are provided at the end of the article.
1. Based on your forecasting and calculations, three similar properties have the following IRRs:
Property A: 8%
Property B: 11%
Property C: 7%
If you believe that all three properties carry the same level of risk, which of these properties is the best investment?
2. Kayla is looking at a property that generates $50,000 in pre-tax cash flow annually. She is targeting a cash-on-cash return of 10%. What is the maximum she can pay for the property while still hitting her target cash-on-cash return?
3. A property that generates $60,000 in NOI annually sells for $1,000,000. What is the cap rate for this property?
4. Cap rates for a given area are currently very low. Is it a better time to buy or to sell?
5. John is weighing several different investment options. In his analysis, he wants to find a growth rate for each investment that considers the purchase price, five years of cash flow, the sale price at the end of a five-year hold, and the time value of money. Which metric would best help him accomplish this?
Answers and Explanations
1. Property B.
The property with the highest IRR is the best investment. This holds true as long as each property has the same level of risk.
Here is our original equation for cash-on-cash return:
Cash–on–Cash Return = Annual Cash Flow (Pre-Tax) / Amount Invested
The rules of math permit us to swap cash-on-cash return with amount invested. This rewritten equation will make it easier to find the value we are seeking:
Amount Invested=Annual Cash Flow (Pre-Tax) / Cash-on-Cash Return
Then, we plug in the values given by the question and solve:
Amount Invested = $50,000 / 10% = $50,0000/ 0.10 = $500,000
Cap Rate = Net Operating Income (NOI) / Purchase Price
Cap Rate = $60,000 / $1,000,000 = 0.06 = 6%
When cap rates are low, it means that property values are increasing faster than rents. Selling in a low cap rate environment is attractive; if you’ve been holding for at least a few years, unusually low cap rates indicate significant appreciation that will benefit you as a seller. When buying, it’s just the opposite — you want to seek out high cap rates.
5. IRR would be the best metric to give John an in-depth indicator of long-term performance. An IRR calculation incorporates the purchase price, projected cash flows, and projected sale price, as well as the time value of money. It does this for each property John analyzes, helping him to compare the properties fairly.
Don’t be intimidated by the process of analyzing potential investment properties. Practice makes perfect, and the more you work with these metrics, the better you will get at using them. Start analyzing your own deals in terms of cap rate, cash-on-cash return, and IRR. The better you get with this, the more efficient you’ll become at scrutinizing deals and picking the winners, ultimately leading you to become a more profitable [LINK: Profitable Short-Term Rental] short-term rental investor.