If you had $200,000 saved up, should you invest in the stock market or in a rental property?
In our previous post, we explored why you may want to consider investing in both the stock market and in rental properties.
However, without the proper tools at your disposal, the choice between investing in stocks or investing in real estate can be tricky.
Fortunately, there are a couple of quick and easy ways to analyze the strength of a rental property as compared to investing in the stock market.
Today, we’ll dive into two metrics that investors use to quickly compare investments across asset classes. The two metrics are known as:
- Cash-on-Cash Return on Investment (CoCROI)
- Return on Investment (ROI)
With just these two metrics, you’ll be able to quickly compare the returns of a potential rental property to the typical returns of the stock market.
You can also quickly compare two different rental properties.
Then, you can decide what’s the best investment for your personal situation.
One note before we begin:
Don’t worry if math is not your thing. There are plenty of online calculators like this one that will do all this math for you.
The key is to understand what the math is telling you. That way you’ll know what to do with the information that the online calculators pump out.
So, before you go running off to one of the online calculators, stick around and see how the math works and what it all means.
Now, let’s think about your options with that $200,000 you’re sitting on.
The S&P 500 historically earns 10% annually.
Before looking at our two real estate metrics, let’s establish a baseline comparison with the stock market.
The S&P 500 has historically earned an average annual return of 10%.
By investing in an index fund that tracks the S&P 500, like I do in my 401(k), I have a pretty good chance of earning consistent returns in the long run.
Sure, there may be ups and downs. And, there are no guarantees the S&P 500 will continue performing at 10%.
But, check this out:
Since 1996, the S&P 500 has ended the year in positive territory 23 times and negative territory only 7 times.
In other words, the S&P 500 has generated positive returns three times more frequently than it generates negative returns.
And even with those 7 negative years, with the exception of 2000-2002, the S&P 500 returned to positive territory the following year.
What this all means is that while the S&P 500 will drop occasionally, the down periods are historically short-lived.
Because of this historical consistency, I feel comfortable using 10% as a baseline to compare other investments with.
Note that predictable returns does not mean guaranteed returns.
There are no guarantees in the stock market or with any other asset class.
To recap: the S&P 500 has historically provided an average annual return of 10%.
While not guaranteed to continue in the future, 10% average annual returns represents a safe projection for our calculations.
That means we can use 10% as a baseline investment return to compare other potential investments to.
With this baseline in mind, we can now move to our two real estate metrics.
Calculate your Cash Flow.
The first step in evaluating any real estate deal is to calculate the expected cash flow.
For a detailed explanation on how to analyze real estate deals and calculate cash flow, check out my post here.
To keep in simple, cash Flow is whatever money you have left over after paying all expenses. Think of it as your monthly profit.
Today, we’ll use an example of a hypothetical property that is listed for $1,000,000.
Here’s a quick snapshot of how you might calculate the cash flow on this property:
Asking Price: $1,000,000
Monthly Rent: $9,000
| Mortgage Payment (Principal and Interest) | $4,500 |
| Taxes | $900 |
| Insurance | $300 |
| Utility Bills | $300 |
| Property Upkeep | $200 |
| Preventative Maintenance | $200 |
| Vacancy Rate (5%) | $300 |
| Unexpected Repairs (5%) | $300 |
| Property Improvements (5%) | $300 |
| Total Monthly Cost | $7,300 |
Cash Flow = Income – Expenses
$1,700 = $9,000 – $7,300
This hypothetical property has a monthly cash flow of $1,700.
That means it has annual cash flow of $20,400, a number that we’ll need for our next calculation.
So, is this property a good deal?
That brings us to our first metric, Cash-on-Cash Return on Investment.
What is Cash-on-Cash Return on Investment (CoCROI)?
Cash-on-Cash Return on Investment (CoCROI) measures how much cash flow a property earns in one year relative to how much money was initially invested.
The formula looks like this:
CoCROI = Annual Cash Flow / Total Cash Invested
With this simple metric, we can compare the return of a potential rental property to the returns of any other investment, like an S&P 500 index fund.
Then, we’ll have some useful information to decide if this is a good deal.
Keep in mind that CoCROI does not factor in appreciation, debt pay-down, or tax benefits. That analysis comes with our next metric.
To continue our example above, we know the annual cash flow on this property is $20,400.
Let’s assume our down payment is 20% of the purchase price, or $200,000.
In addition to the down payment, we paid $10,000 in closing costs and invested another $5,000 to clean up the property before renting it out.
In total, our initial investment is $215,000.
Let’s plug those numbers into the CoCROI equation:
CoCROI = Annual Cash Flow / Total Cash Invested
.095 = $20,400 / $215,000
The CoCROI on this property is .095 or 9.5%.
Does a 9.5% CoCROI automatically mean this is a bad deal?
Back to the important question: is an initial investment of $215,000 to earn $20,400 in annual cash flow a good idea?
What does the math tell us?
We now know that the return on this property in the first year falls just short of the S&P 500’s 10% annual return.
Does a 9.5% CoCROI automatically mean this is a bad deal?
Not at all.
The answer will depend on what your preferences and goals are as an investor.
Keep in mind that CoCROI is a projection tool designed to measure the expected return on this rental property in just the first year.
Because of all of the variables at play, use CoCROI to help you compare investments. But, don’t make your investment choices based solely on the CoCROI.
Also keep in mind that CoCROI is a quick and easy way to compare the initial investment on one rental property to another rental property.
If you’re evaluating a lot of properties, you can quickly see which ones give you the best initial return on your money.
To recap, CoCROI is a great way to quickly compare the returns on different investments in the first year.
However, what if we wanted to evaluate the long-term investment potential on a property?
For example, what if we plan to hold a property for 10 years?
By holding a property for 10 years, we’ll ideally profit through appreciation and debt pay-down, not just through cash flow.
Let’s learn how to factor in those profits by calculating our overall Return on Investment (ROI).
What is Return on Investment (ROI)?
Return on Investment (ROI) factors in cash flow, appreciation, and debt pay-down. It also factors in the sales expenses associated with selling a property after a defined holding period.
Put it all together and ROI is a great way to project the overall returns on an investment over time.
The ROI formula looks like this:
ROI = (Total Profit / Total Investment) / Years
Let’s continue our example to calculate the ROI on this property over a 10-year period.
The first step in calculating ROI is to total up the cash flow.
We already know that this property will earn $20,400 in annual cash flow.
Over 10 years, that means we will earn $204,000 in total cash flow.
Remember, cash flow is only part of our total profits.
Next, we need to calculate the equity we will earn through appreciation and debt pay-down on this property.
Next, figure out the expected appreciation and debt pay-down.
To calculate the rest of our total profits, let’s start with some basic assumptions.
First, let’s assume that this property will appreciate at 3% annually.
Using an online calculator like this one, we learn that our property will be worth $1,343,916 in 10 years.
In other words, since we bought the property for $1,000,000, we have earned $343,916 in appreciation over those 10 years.
Next, we need to calculate how much our loan balance has decreased over those 10 years. This is known as loan amortization.
Recall that our initial loan was for $800,000 because the property cost $1,000,000 and we put 20% down.
Again, we can use a simple amortization calculator like this one to do the math for us.
Assuming a 6.5% interest rate and a 30-year loan, we will have $678,209 remaining on our balance after 10 years.
Since our loan balance started at $800,000, this means that we have earned $121,791 in debt pay-down over those 10 years.
By adding the appreciation and debt pay-down together, we learn that our total equity in this property after 10 years is $465,707.
If we add up our total cash flow, appreciation, and debt pay-down, we see that our total income on this property is $669,707.
Don’t forget to factor in the costs of selling the property.
When we sell this property, we will incur some costs that we don’t want to ignore in our analysis.
Let’s assume that we will pay 6% to real estate agents, 2% in closing costs, and another $15,000 to fix up the property before selling.
In total, that adds up to $107,513 in costs associated with selling this property.
When we subtract the sales expenses from our total income, we see that our total profits on this property after 10 years are $562,194.
Now that we know our total profits, we can calculate the ROI.
How to Calculate ROI.
We now have all of the pieces we need to calculate the ROI on this property.
As we added up above, our total cash flow, appreciation, and debt pay-down, combine for a total income on this property of $669,707.
When we subtract the sales expenses from our total income, we see that our total profits on this property after 10 years are $562,194.
We also saw above that we made a total investment of $215,000 (our down payment plus closing costs) to acquire this property.
Now, we can plug this information into the ROI formula.
ROI = (Total Profit / Total Investment) / Years
.261 = ($562,194 / $215,000) / 10
ROI or Total Return: 26.1%
In the end, this property generates a total annual return of 26.1%.
So, what should you do with your $200,000?
Is this property a good deal?
Would you be better off investing in an S&P 500 index fund and earning 10%?
Using CoCROI and ROI can help you make that decision.
As an investor, you may be thrilled with a 9.5% CoCROI or 26.1% ROI.
On the other hand, you may not be interested in doing the work and taking on the risk involved with owning that rental property.
Remember, we are making projections based on a number of variables. Nobody can predict exactly how an investment will perform.
In the end, only you can answer this question based on your personal preferences.
The point in doing the math is to provide additional data points so you can make the best decision possible.
There’s no right or wrong answer.
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