Here’s a question. Suppose an apartment generates Php20,000 in pure cash flow per month. Would you consider that a good investment?
Well, it depends.
Two vastly different properties, bought at entirely different amounts, can generate the same cash flow. While the Peso amounts you get are also important, rates of return are better measures for assessing investments.
Today, let’s talk about the smarter way of analyzing investments and the drawbacks to using an approach based purely on Pesos received.
Ways to Analyze Investments
There are many ways to examine investments. The most basic approach is to determine the Peso amount you expect to get. We like this approach because it’s easy to understand, and there’s little to interpret. In our example, this was Php20,000 per month. In contrast, we can also use the returns we expect the investment to yield. Think about bank interest rates, which are a simple form of investment returns. We like this approach because different investments then become comparable. There are more detailed iterations under both approaches — the NPV for the “Peso approach” and IRR for the “returns approach” — but we don’t need to know them now.
Which of these two is a better approach? There are pros and cons to each. For instance, we can manipulate the returns approach by changing our investment amount. On the other hand, the Peso amount doesn’t consider our investment amount altogether. Let’s revisit the Php20,000 question. If the investor financed the apartment at Php2 million, then the annual return, at Php20,000 per month of pure cash flow, is 12%. That is Php240,000 received over the year, divided by Php2 million. For now, we’ll keep it simple and ignore leverage, the time value of money, and so on. But supposed the total investment was Php20 million. In that case, our returns shrink to 1.2%. The Php20,000 per month then becomes a poor investment. Why? Because of opportunity cost: You could’ve used the Php20 million and invested in, say, REITs. REITs in the Philippines have 4% to 6% yields, notwithstanding the potential for capital appreciation. At a net yield of 5%, the Php20 million investment generates Php83,333.33 per month. All this without the hassles of property management. In other words, there’s no reason to spend Php20 million on this particular apartment if it generates just Php20,000 a month.
There are many more metrics to choose from, each having its drawbacks. I like to combine approaches because their strengths complement each other’s weaknesses. The 7 Metrics I use to determine if real estate profitability is good are the cash flow per unit, cash-on-cash return, return-on-investment, return-on-equity, the one percent rule, net present value, and the internal rate of return.
One way to instantly boost returns is to be mindful of how you build your apartments. Staying emotionally detached is key — you aren’t building the apartment to live in. Remember that each Peso spent reduces your returns, all things the same. And that’s the tricky part. Some improvements may mean you get to increase rent. While others are “wasteful” expenditures that don’t do anything to improve perceived value. (See How to Value an Apartment Building). Whatever the case, minding your returns is an essential aspect of analyzing investments. But that’s just one step. The next is to manage your risk-adjusted returns. Although, that’s a story for another day.
Bio: Dan Dima-ala is a 2-time real estate board exam top-notcher, real estate investor, entrepreneur, and former corporate finance professional. He has a degree in economics & finance and is a certified Accounting & Finance Mentor for GoNegosyo. As a financial freedom advocate, Dan shares his unique insights at freedom locker PH.