- October 21, 2020
- Posted by: Editor
- Category: Investment
Grasping the concepts of return on investment and risk in real estate is an important skill to acquire early in your investment career. While data, metrics, and calculations should be your ultimate guide, it can’t hurt to start with a basic foundation for assessing risk-return trade-off.
The easiest way to quickly determine the return on investment and risk associated with a property is to assess it within property classes. These classes are not rigid, however, and should only be used as a general basis for risk analysis.
When first analyzing real estate investments off of limited information, you can likely place a property somewhere within classes A through D.
Classes of Property in Real Estate.
There are 4 property classes in real estate. Each comes with a certain risk and return on investment.
Class A properties are located in the best neighbourhoods for the highest price points. They are also the most stable investment properties with the lowest risk and, consequently, the lowest return on investment.
Class B properties are priced slightly lower and reside in primarily middle-class neighbourhoods. With a little elbow grease, class B properties tend to appreciate well. This type of investment property has somewhat more risk involved, though the higher return on investment makes it appealing.
Class C properties are found in poorer neighbourhoods, and you will get them at a discount. Adding value to these homes can skyrocket your return on investment, but be wary of the high risk associated with owning them. Between extensive repairs and low occupancy rates, these high-risk investments are trickier to navigate. Though, for the right real estate investor, they can be extremely profitable.
Class D properties are distressed homes in the worst neighbourhoods. You should think of them as far riskier versions of class C properties. They come at an incredible discount. Low prices allow for a potentially high return, but only extremely experienced real estate investors should consider taking on these kinds of high-risk investments.
Return on Real Estate Investment Through Analysis
As you can see from the above examples of property classes, the higher the risk the higher the return. Low-risk investments are only ideal for investors interested in a slow, long term, steady return on real estate investment. That being said, most investors are interested in a little risk. Taking on some risk means seeing higher profits and cash flow.
So, given that there is a trade-off, how much risk is too much?
When it comes to return on investment and risk, investment property analysis is the only way to determine the worthiness of a potential investment. Investment property analysis will give you hard numbers you can use to make high return real estate investment decisions.
Calculating Rate of Return on a Rental Property
There are three ways to measure return on investment and risk in real estate. These calculations are called return on investment, cap rate, and cash on cash return.
- Return on investment (ROI) is a figure represented as a percentage. It shows the gross rental income earned from a property versus the total cash investment. This is a good general starting point, though you will want to make the other calculations as well.
ROI = Annual Rental Income/Total Cash Investment
A decent ROI should fall at 15% or more on average.
- The cap rate (or capitalization rate) is another percentage that represents the rate of return in terms of both the total price of a property as well as ongoing expenses.
Cap Rate = Net Operating Investment/Price
A good cap rate is at least above 8%, though preferably above 10%.
- Cash on cash return is a percentage as well. This metric provides a good representation of the rate of return in relation to the ongoing property expenses in addition to only the cash actually invested.
COC Return = Net Operating Investment/Total Cash Investment
Like cap rate, good cash on cash return falls at least above 8%, but even more preferable is above 10%.
When it comes to return on investment and risk in real estate, we know that high-risk properties typically come with higher potential for returns. However, not every property is capable of living up to its potential. There are many factors that can influence an investment property’s performance. Without the right real estate investment software, you won’t be able to properly assess the value of a particular investment.
The average return of investment in the Nigeria should help you to gauge where your property falls in terms of return on investment and risk compared to the national average. It is also helpful to look at local statistics, as those numbers can vary dramatically depending on location.
Ultimately, you want to strike a balance of return on investment and risk that fits your experience level, cash reserves, investment strategy, and overall risk tolerance. Less experienced investors may find that low-risk investments are a smart move to start with. Long-time investors may opt to recover risky properties because they know what to look for.
Whether you choose to take on risk in your investments or not, every smart investor understands that their success depends on the data and calculations only powerful real estate investment tools can provide.