There is a lot of misunderstanding about how to invest in real estate. There are even more misconceptions about what makes good investments and how to evaluate them. While it might seem like an arcane topic, real estate investing can be very simple if you understand some basic concepts. This article covers the most important basics of real estate investment: opportunity cost of capital, yield, return on investment (ROI), internal rate of return (IRR), leverage and debt coverage ratios, interest rates/taxes and rent/price ratio.
The opportunity cost of capital
One of the most important concepts in real estate is opportunity cost. The opportunity cost of capital is the returns on investment you could have made if you had invested elsewhere. So, if you invest 100,000 € into a property, that means that 100,000€ is no longer available to invest elsewhere.
The reason this concept is important is because it applies to all investments—not just real estate or stocks and bonds: every investment decision involves giving up another option for your money. For example, when you decide not to purchase a home because there’s less risk involved with paying rent than buying a home yourself (with more risk), then what are those risks? You forgo any potential appreciation in value over time; in addition, the insurance premiums may be higher than expected as well as maintenance costs down the line which can offset any potential gains from appreciation after all expenses have been accounted for (which often isn't taken into account).
Yield
When you're considering a specific investment, one of the first things that people look at is the yield. Yield is the annual return on investment and represents the ratio of income to the cost of owning an asset. It tells you roughly how much money will be coming in each year (or quarter) from your investments compared with what they cost—and if it makes sense for your goals.
For example, if an investment of 100,000 € is required to receive an annual rental income of 5,000€, the yield would be 5%.
At Asai, we would not consider any investment with a gross yield of less than 6%.
Return on investment
Return on investment (ROI) is the ratio of profit to investment. It's the amount you earn after taking into account all costs, including taxes, property management fees and other expenses. The higher ROI, the better your property will perform and increase in value over time.
Internal rate of return
Internal rate of return (IRR) is the discount rate that makes the present value of all cash flows equal to the initial investment. IRR is often referred to as the return on an investment, but this isn't technically accurate because it ignores the time value of money.
Leverage and debt coverage
Leverage is the amount of debt an investor can use to purchase a property. The more leverage you have, the more money you can borrow to buy a property and set up your real estate portfolio. However, there is also risk involved with this strategy: if there's an unexpected fluctuation in rent prices or maintenance costs, then you may not be able to cover your mortgage payments with rent income alone.
The debt coverage ratio (DCR) is used for determining whether a property will generate enough cash flow to cover debt service. It measures how much net operating income (NOI) is generated by a property compared with its annual mortgage payment.
Interest and tax rate
Interest and tax rates are both important factors in your investment decision. The interest rate is the cost of borrowing money, while the tax rate is the percentage of income that you pay in taxes. If you have a high tax bracket, your return on investment will be lowered by paying more in taxes.
It is important to note that in Spain different regions have different tax rates and it is important to seek professional advice.
Rent/price ratio
Rent/Price Ratio is a very important concept to understand in real estate investment. It's the ratio of the rent to the price of the property. The higher the ratio, the better.
The value of any investment property can be determined by looking at its Rent/Price Ratio (RPR). This is because it's not just about how much money you make when you buy something; it's also about what your money will be worth once you sell it later on down the road. A good RPR means that there are plenty of tenants available who are willing to pay a reasonable amount for housing and utilities, which means that your return on investment will be better than if there weren't so many tenants around paying high amounts for their place(s).
Investing in real estate is a good idea if you can get the numbers right.
You’ll need to consider what the property is worth, what it will take to refurbish or renovate and how much money you can make when you sell it. It's important to have that information before deciding on a property.
For Spain, we consider yield and IRR to be deciding factors.