There are a few numbers that are important in your investing journey and you need to calculate (it’s easy!), to compare investments against each other to enable you to select the best ones. Those are equity, net worth, cash flow, Return on Investment (RoI), yield, and gearing ratio. Those numbers tell you which investment you should go for.
Equity: Equity is the difference between the current market value of a property less the liabilities you have against it. For example, if your house is worth $300,000 and you have an outstanding mortgage of $120,000 against it, the equity you have is $180,000.
Formula: Equity = Market Value – Liabilities
Net worth: Tells you how much you are worth overall and is the difference between all your assets (properties and otherwise) and all your liabilities. For your property portfolio the net worth is therefore equal to the summation of all the equity in each property. For example, if you have three properties worth $500,000 in total and mortgages totaling $250,000 against them, and $50,000 in the bank, your net worth is $300,000.
Formula: Net Worth = Overall Assets – Overall Liabilities
Cash Flow: Your cash flow tells you how much you are earning (or losing) net from your property every month. It is simply the difference between all the money that comes in from rental income and all outgoings such as financing and operating costs. You can find a sample calculation under the Buy To Let strategy.
Formula: Cash Flow = Incomings/Rent – Outgoings/Expenses
Return on Investment (RoI): The higher the RoI, the more efficient your investment and you make your money work harder. There are two ways to calculate RoI – based on the total investment (Gross RoI) and based on how much of your own money you have invested into the deal (Cash-on-Cash, or CoC in short). If you buy the property with full cash (no mortgage), these two numbers are the same, but the less of your own capital you use, the higher the CoC can get. The RoI compares how much net annual cash flow you are getting compared to the sum you invested. For example, if you buy a property for $100,000 that gives you a net annual cash flow of $3,600 and you use $35,000 of own cash and take a mortgage of $65,000, your Gross RoI is 3.6% (3,600/100,000) and your CoC is 10.3% (3,600/35,000) – almost three times as high! That is the power of leverage.
Formula: Gross RoI = Net cash flow/Total Invested capital
Cash-on-Cash RoI = Net cash flow/Own invested capital
Yield: Yield measures the income you get versus the market value of the property. It can be compared to the interest rate a bank might give you for a term deposit. The higher the yield is, the better for you. For example, if the market value of the property you bought in the RoI illustration was worth $110,000, your yield would be 3.3% (3,600/110,000).
Formula: Yield = Annual Rent/Market Value
Gearing ratio: Gearing ratio means how high you have leveraged your investment. Referring to the RoI example again, the gearing ratio in the case of CoC is 65% as you have used 65% of money that was not your own. There is no optimal number for your gearing ratio as it depends on your personal situation, but if it is too low you don’t make efficient use of your money and if it’s too high, you are taking a big risk. Personally I see comfortable numbers somewhere between 50% to 70%, but you’ll be your own judge.
Formula: Gearing Ratio = Liabilities/Market Value
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