The best way to make a good investment is to understand and appreciate the fundamentals. The basic financial concepts provide an investor the tools necessary to distinguish a good investment from a bad one. It helps to answer questions such as; how can an asset increase in value and provide a good return? How can you invest to minimize your risk and create more wealth?
Being able to evaluate an investment from a financial perceptive is crucial if you want to succeed in business. While there are a lot of factors to consider, the core fundamentals are what would give you an accurate assessment to make good financial decisions.
If you can add up all income and expanses an investment makes you off to a good start! If we look at the properties and an investment class, if you take annual gross income property makes and subtracts its annual expenses, you can calculate the properties NOI or net operating income. This as an important number to consider especially if you considering to scale up and acquire more assets. There’s a lot to NOI that would require a chapter alone, but we keeping it simple here, after all, this supposed to be a quick and easy calculation.
Return-on-Investment (ROI) is a percentage that measures how much cash a property generates annually in comparison to how much cash you contributed upfront to acquire the investment. ROI also referred to as the Cash-on-Cash Return, is an important metric when determining the feasibility of investment.
ROI = (Annual Cash Flow / Initial Cash Investment) x 100
These two concepts, ROI and NOI, might seem overly simplistic but understanding their implications on an investment can help to appreciate the importance of cash. The short term decision based on these fundamental concepts has irreversible long-term implications.
Randy is a full-time IT professional that is looking to put some of his hard-earned capital into property investments. Randy enlist the help of a reputable agent who sends him an email for an opportunity that just opened up. The agent provides Randy with an opportunity to buy a 3 bedroom unit in a well know area for R500K. The apartment will generate R120K per year, this is the Gross Income Randy could expect.
Next Randy adds up all the operating expenses such as maintenance and repairs, insurance, property tax, levies, advertising, etc. The total annual expenses for the unit comes up to R50K.
Randy works out the NOI by subtracting the annual operating expenses from the annual gross income:
NOI = Annual Gross Income / Annual Operating Expanses
NOI = R120K – R50K
NOI = R70K
Randy is going to leverage the bank’s money to help him finance 80% of the purchase price. Leaving Randy to come up with R100K at closing.
Bank Finance R400,000
Cash + R100,000
The bank is able to finance the deal at a 10% annual interest rate with a 20 year amortization period. The resulting bond payment being R3,915.32 per month, so lets round that off to R48,000 per year. This is called your annual debt service.
Now let’s calculate our ROI by subtracting the net operating income from the annual debt service:
Net Operating Income R70,000
Annual Debt Service – R48,000
Cash Flow R22,000
Since Randy put R100K of his own cash, he positions himself to receive a return-on-investment of 22% in the first year of operation.
ROI = (Annual Cash flow / Initial Cash Investment) x 100
ROI = (R22,000 / R100,000) x 100
ROI = 22%
We can also make a calculated assumption that Randy is in a place to get all his money back in 4.5 years:
Payback Period = Initial Cash Investment / Annual Cash flow
Payback Period = R100,000/R20,000
Payback Period = 4.5 years
Now let’s consider that Randy is decreasing his debt by using his cash flow to pay down his principle on the bank loan. In this scenario, your principle pays down after 5 years will total approximately R183K. This principle pay-down can eventually be accessed by refinancing the property, increasing Randy’s cash flow to approximately R44,500 annually, that’s a 44.5% return-on-investment…Cha-Ching!
This is not even taking into account other strategies such a depreciation, tax-incentives, and ways of reducing expenses that can boost Randy’s cash flow. By strategically putting cash to work in places that will boost his NOI, Randy can accelerate his growth by acquiring more properties and recycling this strategy.