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There are many ways to evaluate investment returns when you purchase an income property. But you are the only one who can choose which evaluation and analysis method is appropriate for you and satisfies your personal decision on the best investment. Let’s cover a few of the well-known ways to evaluate investment returns to hopefully provide some additional guidance for your decision making.
Appreciation in ValueMany people buy a property, and their main criteria or investment analysis is that it will go up in valueover time. This is probably the most common way that buyers evaluate real estate. The problem with this method is that it doesn’t take into account the cash flows the property can generate. And you need to beware of those negative cash flows, as noted below.
Cash-on-Cash ReturnCash-on-cash return is calculated by taking your estimated, or proforma, cash flows and dividing them by the amount of cash equity you invest to purchase the property. For example, if I invested $40,000 into a property and earned $4,000 per year in free cash flow, that’s a 10% cash-on-cash return—and a very good deal if those numbers come true.
You can also buy properties that have negative cash flows, typically fancy prize downtown condos or properties in the most expensive areas of town. I don’t recommend buying these because it could be several decades before they truly turn positive, and all those years you will be covering that negative cash flow via investing additional equity. Note that positive cash flow properties pay you, while negative ones keep taking additional money out of your bank account.
