By guest contributor Gerald Tay
In the first part of this article, we talked about the importance of looking at numbers instead of location when buying investment property. There are two vital numbers that novice investors and speculators frequently ignore: the Cash-on-Cash Return and Internal Rate of Return. Let’s now take a closer look at those two vital numbers.
Cash-on-Cash Return (COCR)
Most novice investors and speculators look at net yield only. This can be highly deceiving as it does not tell you if your money is safer in the bank or if you can get higher returns in other investments.
The calculation of net yield is typically based on the purchase price, rental income and net of all expenses except mortgage payments. The difference between net yield and COCR is that the latter factors in both the principle payment as well as the interest on the mortgage loan, including all other expenses incurred.
Novice investors and speculators only look at the purchase price or PSF because they buy on the hope of capital appreciation, which can be highly dangerous. Professional investors look at the COCR – that is, if you were to put in your initial sum of capital (including stamp duty, downpayment, renovations costs, legal fees, etc) minus all property-related expenses (including mortgage and interest), what will the actual return on capital be in the first year? Will your money be safer in the bank instead?
Internal Rate of Return (IRR)
Professional investors use this tool to measure and compare the profitability of investments. It can also be defined as the annualised effective compounded rate of return. It is quite similar to COCR, except that it measures a period (years) of different cash-flows yielded by the investment till the point of exit. Because it is a rate of return, it is an indicator of the efficiency, quality and yield of an investment.
An investment is considered acceptable if its internal rate of return is higher than the minimal acceptable rate of return or cost of capital. Example: If your minimal acceptable rate of return according to your overall investment plan is 10%, and the IRR for the investment deal upon exit after five years (before inflation and possible interest rate increases) is 8%, then it is definitely not worth your while to enter.
Similarly, if your cost of money (borrowing) is 1% today, your acceptable rate of return is 8% and your investment potentially yields an IRR of 10% over five years, then it may be worthwhile to enter as there is a safety margin and it meets your target requirement.
How professional investors think about the purchase price
The COCR and IRR measure the actual performance of your property and take into account the value you can get out of your investment property.
When I look at an investment, the purchase price is the last of my considerations. It is only used because I need to compute both my COCR and IRR to determine the value of the investment.
Novice investors and speculators pay the seller’s price or market price. Professional investors dictate the price to pay to the seller, not the other way round! If the price does not reach my targeted benchmark for both the COCR and IRR in my negotiations, I will walk away from the deal, no matter how good an investment others say it is.
The purchase price can be high, but if I can get value through both the COCR and IRR, I know I have a winning investment.
Put money in your pocket immediately
Remember, a good property will always put money in your pocket. A bad property takes money out of your pocket. Buying a property in a not-so good or average location but that puts money in your pocket today is lot better than buying a property in a good location that takes money out of your pocket every month. But please do not rush to buy properties in areas where (as the Chinese saying goes) “even the birds don’t lay eggs” based on this statement. Do your own due diligence first!
I know someone who bought a three bedroom condo in Woodlands during the SARS period in 2003. She bought it at a very low price, in the region of S$400,000, and paid cash for it. Today, she is enjoying the rental income generated every month from her tenants, with a net yield above 10%.
I am not saying you need to pay full cash payment for a property to be able to enjoy such yields. I strongly believe leverage is a very powerful tool especially in real estate investment. All my properties are leveraged. My point is that if those unleveraged numbers make financial sense, then the property is a good investment even in an average location like Woodlands.
Make investment decisions based on actual numbers
So now you know why professional investors seldom lose money – because they make key critical buying decisions based on actual numbers, not on speculation that a property has goo growth potential or because it is in a good location. Professional investors do not count on “potential” to make money – that is a bonus. The smart investor will gain both good cash-flow as well as capital appreciation if this bonus happens. If the “promised” potential growth does not happen for whatever reason, there is still positive cash-flow from the property.
The next time someone tries to sell you an investment property (especially the new launches nowadays), simply ask for these two numbers from them. If they stare at you with a blank look (most likely because they have never heard of COCR and IRR) and say it is a good investment simply because it has a really good “potential net yield” and it is in a “good location”, take that as a red flag!
Any investment will carry a certain amount of risk – understanding these two key numbers will help mitigate those risks substantially and propel you forward in your investment journey.
By guest contributor Gerald Tay, CEO and Chief Trainer at CREi Academy Group.