If you’ve seen the iconic film Indiana Jones and the Last Crusade, you’ll recall the climactic scene where Indy needed to pass four tests in order to retrieve the Holy Grail. The margin for error was razor thin, and the stakes were high. One wrong move and he would have failed the test and lost everything, including his head (as would have happened had he not knelt as the penitent man to pass the test).
When we make investments, we focus on the reward and balance it against the risk. These four tests, as far as I am concerned, will allow us to get to the Holy Grail of wealth without losing our heads.
1. Cash on Cash Return ($/$)
Cash on cash return is a tool used to calculate the value of investment property based on your actual cash investment versus the income the property will generate.
Cash on cash return is expressed in a percentage that reflects the amount of income each year against the initial cash investment. This investment metric is calculated by taking your net income and dividing this by your initial investment to determine the percentage. Your initial investment will include the following start-up and acquisition costs:
- Down payment
- Inspection, appraisal, and any other due diligence costs associated with the acquisition
- Total of repair and renovation costs
- Closing costs
Your annual net rental income will include your total rental income less your annual recurring expenses—the result of which will tell you whether the investment will have a positive or negative cash flow:
- Property taxes
- Maintenance costs
- HOA fees
- Property management
- Vacancy rate
Cash flow divided by cash invested equals cash on cash return. If you’re seeing between 5% and 10%, you are in the zone, generally speaking, taking into consideration the specific property risk and current market. Watch this video to create yourself a simple Excel calculator to build your four-test worksheet.
2. Net Present Value (NPV)
Net Present Value is a metric used to calculate the present value of your net future cash flows from an investment property.
This metric is valuable in establishing the yield of an investment. It is based on whether anticipated future cash flows will present a value larger than what is required to invest in the property. Therefore, allowing an investor to calculate a yield that can be compared to other potential properties and opportunities by the same measuring stick. To calculate NPV, future cash flows are discounted by the desired rate of return and deducted from the initial capital invested. In order to calculate IRR, you will need to begin with the following:
- The total holding period in years
- Cash flow generated each year
- Discounted rate of return
- Initial cash investment
This calculation is used to tell us if the present value of future benefits is greater than or equal to the cost of those benefits, thus providing your desired rate of return. You will want to see a positive number as a result, as that will mean the investment outperforms your expectations.
3. Initial Rate of Return (IRR)
Internal rate of return is a key metric in the valuation of a potential investment used to show profitability by determining a discount rate that makes the net present value of all cash flows equal to zero.
It uses the same information need to calculate NPV to determine the initial rate of return with the NPV set to zero and solving for the desired discount rate. This tool will provide you with a projected rate of growth expected from the investment. You want to see a positive number in this category, and generally speaking, the higher the IRR, the better the investment. This calculation is valuable in comparing multiple properties by creating a level playing field in which to do so.
With IRR, there is no magic number. In most investment properties that are currently being underwritten, an IRR of 10% or less seems to be more of a negative result, while an IRR of 15% or more are generally found to be good investments.
4. Modified Internal Rate of Return (MIRR)
Modified internal rate of return takes your desired investment goals into consideration with reference to the determined IRR and overall financial metrics contributed to that calculation.
Pre-investment will help you determine how much initial capital investment is needed and evaluate your rates of return on that initial amount. During the holding period, your cash flow analysis will help you determine your returns during the life of the investment period. Finally, MIRR will help you determine your exit strategy by taking your projected sales price and returns and evaluating them against the returns of other investments, varied hold times, and how much to invest initially for the best overall return. MIRR is the big picture calculation that comes as a result of these metrics and gives you an overall snapshot on returns to make your final evaluation of the property. Here is another useful video to help you build your own custom investment input worksheet along with your cash on cash calculation.
Equipped with this newfound knowledge, you’ll be able to assess potential investments to see if they pass each of these four tests as you evaluate both the short and long term performance of the investment. I strongly encourage you speak with a local property manager who has knowledge of the area to help determine the income to expense ratio so you can input accurate cash flows into your model. I would also never recommend a rent increase of more than 3% per year.
By following this guidance, you can avoid making poor choices, such as the one Marcus Brody made at the end of the movie when he was fooled by appearances and drank from the wrong cup. “He/She chose poorly” can be avoided. To put it simply: Never invest in something simply because it is shiny.