As an investor, wouldn’t it be great to have a single metric that could tell you if a property is a good investment or not?

While this is a dangerously simplistic question to ask, we will attempt to answer a more precise question.

How do I evaluate the returns generated by a potential investment?

There are several bottom-line metrics that you could use to evaluate the returns generated by your real estate investment. We will be discussing three main metrics in this article:

• The Total Return on Investment (ROI)
• The Net Present Value (NPV)
• The Internal Rate of Return (IRR)

We will go in depth on how to calculate each metric, explain the assumptions and limitations made behind each of them, and provide you with a range to benchmark your metric against.

The Total ROI

Definition

The total ROI is a single number that takes into account the price gain you expect to make from selling your investment and the total cash on cash return on investment.

In essence, the Total ROI takes into account the total profit you will generate from an investment, whether it is from cash flow or from price appreciation.

Example:

You intend to purchase a property that is priced at a 1,000,000 AED in cash (closing costs included). The property is expected to produce a net operating income of 100,000 AED a year and you finally expect to sell it in 3 years for 1,200,000 AED.

Your Total ROI, in this case, will be calculated in the following manner:

Step 1 — Calculate your cash on cash ROI

Cash on Cash (CoC) ROI = Free Cash Flow / Equity

Cash on Cash (CoC) ROI = NOI / Purchase Price [since the property is fully bought in cash]

Cash on Cash (CoC) ROI = 100,000 / 1,000,000 = 10%

Step 2 — Calculate your price gain

Price gain = (Selling Price — Purchase Price) / Purchase Price

Price gain = 1,200,000–1,000,000/1,000,000 = 20%

Step 3 — Calculate your Total ROI

Total ROI = CoC ROI x 3 years + Price gain = 10% x 3 + 20% = 50%

Things to keep in mind

The word ‘ROI’ gets thrown out so carelessly in the market, especially by agents trying to convince you of a deal in Dubai.

At times, agents use it to only refer to the cash on cash ROI for a secondary apartment, while for an off-plan listing they might just mean the price premium that you will expect.

Make sure you know exactly what ROI your agent is referring to and more importantly ask for how long of a timeline they are speaking of, and whether they assume you will be buying the property in cash or whether you will be taking a loan to finance your purchase.

Limitations and Assumptions

It is quite the common case that when calculating the ROI, people assume that cash on cash returns are going to remain fixed and that is not too bad of an assumption if the investment timeline we are looking at is for the short-term but this completely disregards any motion in rents whether positive or negative on the long term.

The ROI could be easily over-estimated by an optimistic projection of the price gain, or an underestimation of operating expenses and thus an inflated CoC ROI.

The longer the time horizon that the total ROI is being predicted on, the less accurate the estimate.

Benchmark

A property with a total ROI greater than 20% on a one-year timeline is a decent investment. This means a combination of a 10% price gain and a 10% CoC ROI from year 1 would be considered a proper deal.

The Net Present Value (NPV)

To understand the net present value, you will need to understand what I mean when I refer to the time value of money and the opportunity cost of money.

If a friend comes up to you and says lend me an X amount of money, and I’ll give you back 100,000 dollars in a year’s time.

What is the maximum amount of money you will be willing to give?

It will be less than a 100,000 dollars, that’s for sure.

Here’s how you should go about it:

What is the return of the best investment alternative with the same risk of lending your friend?

Let’s say instead of lending your friend money, you could invest this money in the stock market and get a 10% return on your investment.

Then, in this case, your discount rate, or in fancy words, “your minimum acceptable internal rate of return”, will be 10%.

So let’s discount your friends 100,000 dollars by 10%, the present value of this money will be 100,000 / (1+discount rate) = 100,000/(1+0.1) = 100,000/1.1 = 90,909 dollars.

In other words, 90,909 dollars will be the maximum amount of money you will be willing to invest in your friend to guarantee a 10% return.

NPV Definition

The net present value, in general terms, is calculated by discounting each year’s cash flow and then taking the sum of all the discounted cash flows.

Example

Let’s say you are actually lending your friend 80,000 dollars, but this time he will be paying you back 60,000 dollars in the first year and another 60,000 dollars in the second year.

Assuming your discount rate is still 10%, your net present value will therefore be calculated as follows

Present Value of Year 2: PV2 = 60,000/ (1+0.1)² = 60,000/ 1.21 = 49,587 dollars

Present Value of Year 1: PV1 = 60,000/ (1+0.1)¹ = 60,000/ 1.1 = 54,545 dollars

Present Value of Year 0: PV0 = -80,000/ (1+0.1)⁰ = -80,000/ 1 = -80,000 dollars

Net Present Value = PV0 + PV1 + PV2 = -80,000 + 54,545 + 49,587 = 24,132 dollars

Two things to note here:

1. Your net present value is positive which indicates that, according to your discounted rate, this is a profitable investment.
2. The total profit in today’s dollars is only 24,132 dollars and not exactly 40,000 dollars (-80k+60k+60k).

Limitations and Assumptions

The net present value is a very comprehensive metric since it takes into account the opportunity cost of capital. However, keep in mind that NPV is highly sensitive to the discount rate(s) assumed by the investor.

So when assessing the NPV of an investment, in addition to checking the cash flow numbers, you will need to make sure that the assumed discount rate is a reasonable estimate of your opportunity cost.

The Internal Rate of Return (IRR)

Definition

You could think of the internal rate of return as the annual discounted ROI, or in simpler terms, it is the effective annual return on your investment.

Another way of thinking about IRR is that it is the discount rate that will make your net present value zero. In other words, if your discount rate was greater than your IRR then you are losing money.

Calculating the Internal rate of return is not a simple process, instead, it is a trial and error process of trying to estimate the discount rate that will result in a net present value of zero. However, most of the readily available spreadsheet software (google sheets, numbers, Microsoft excel) has a built-in IRR function.

You will need to start with an initial guess and try to estimate the discount rate.

Example:

In the above example where you are lending your friend 80,000 dollars and receiving back 120,000 dollars equally split over two years. Your IRR turns out to be around 32% (you can double check by calculating the NPV and making sure it is zero).

Limitations and Assumptions

The internal rate of return has a built-in limitation that it assumes the discount rate will remain fixed across time. This is not the case in real life, especially now when interest rates are poised to start increasing and thus directly affecting your opportunity cost of capital.

Benchmark

A property with an IRR greater than 15% is a decent investment. Aim to purchase a real estate investment with an IRR of around 20% or more to guarantee great returns.

A Final Word

Remember this: Numbers can always be adjusted to fit your preferences.

You will need to scrutinize your investment return metrics carefully. Check to see if you are being overly optimistic in estimating gains, or whether you are underestimating any of your expenses.

Now it doesn’t mean that an investment with the highest returns is the best investment for you. Make sure you properly assess any potential off-plan or ready investment by looking at the whole picture, the risk involved, the projected investment timeline, and other factors before you decide whether all this aligns with your objectives.

Is investing in off-plan a much wiser choice than buying a ready unit from the secondary market?

I bet you might have heard that it is way better to invest in off-plan in Dubai. “That’s where the real money is made” some might say.

Others might have claimed that you are “better off gambling your money in Vegas than investing in off-plan”.

What I want to do in this blog post is give you a framework for thinking about the off-plan versus ready decision for an investment.

The key takeaway I hope you get after reading this article is there’s not just a simple right answer.

To answer this question, we are going to study the case of purchasing a 1 bedroom apartment in DSC (Dubai Sports City).

We will look at the option of either buying a ready 1-bed apartment in DSC or investing in an off-plan 1-bed apartment.

We will then conduct a sensitivity analysis changing multiple inputs and seeing how this will sway the final outcome. In closing, we will hopefully have a well-formed idea of how much better or worse it is to invest in off-plan.

To fully understand this analysis, however, you will first need to understand the time value of money.

The Time Value of Money

If you have to choose between receiving a 100,000 dollars today versus getting a 100,000 dollars one year from now, what would your choice be?

It is almost so obvious that getting a 100,000 dollars today is a much better decision.

Why is that? I’ll give you a clue: It is not because you’re impatient. Instead, it is for the simple reason that throughout a year you could have invested this 100,000 dollars and made more money.

You could have placed this money in the stock market for instance and made at least 6% returns in one year. This means that I would have to offer you at least 106,000 dollars one year from now to make you an equally attractive offer.

The same applies in real estate: when evaluating an investment’s cash flow you will have to discount each year’s cash flow with your opportunity cost [or discount rate] to come up with the net present value of all the money you would have made.

The Net Present Value (NPV) is the bottom line metric we will need to look at to inform our decision. You would want to know in absolute terms how much money you would be making from this investment in today’s terms.

The investment option with the higher Net Present Value is the more lucrative option. This says nothing about the inherent risk carried by each option, however, something we will discuss at the very end of this analysis.

Case Study

For our case study, we will be comparing between the following two options:

Option 1:

• Property Type: 1 bedroom apartment in Dubai Sports City
• Price: 800,000 AED
• Size: 1,100 sqft
• Expected Rental Income: 71,600 AED
• Total Operating Expenses: 13,800 AED

Option 2:

• Property Type: 1 bedroom apartment in Dubai Sports City
• Price: 800,000 AED — We will vary the price to see how this influences the outcome
• Size: 1,100 sqft
• Payment Plan: 60 / 40 — We will also vary the payment plan
• Completion Date: 2020

In qualitative terms, here is a brief comparison between the two decisions:

Option 1 — Investing in a ready apartment

Option 2 — Investing in an off-plan apartment

You will have to spend a lot of time to locate an under-priced property

You can easily get a nice price premium below current market prices of ready apartments

You have full control of your investment from Day 0.

Control is with the developer until construction is completed and property is handed over to you

You don’t have to pay any pre-registration fees, your procurement/closing costs are much lower than when purchasing off-plan

You will most likely have to pay an Oqood Registration Fee of 4% of the purchase price

You can take out a mortgage to finance your investment from Day 0

Banks usually offer to finance only after 50% of the payments have been completed by the buyer. Banks are very picky about which projects they approve for financing.

You can directly start generating cash flow through rental income

You will have to wait till project handover before you can generate any cash-flow

When it comes to selling the apartment you can do so at any time.

If your property is not yet completed and final payment has not been made then the developer will need to be consulted on transferring the payment plan to the new owner and to confirm that your payment installments are up to date in line with your original Contract of Sale. It may be included within your initial Purchase & sales Contract that a certain amount of the total purchase price (e.g. 40%) must be paid before Developer will approve a resale. Additionally, for off-plan property sales, the developers may set an MSP (minimum selling price) so to not undercut their available primary sales.

What you see is what you get

You will have to hope that the delivered apartment looks similar to the one in the brochure

If you are buying in an old or low-quality building, asset deterioration is a real problem, and you might have to end up paying a huge bill a few years down the road to replace the elevators or the fire pumps.

You are hopefully buying a building with brand new equipment set in place so you won’t have to worry much about paying any unwanted expenses in the near future.

When it comes to selling the property, you might have to spend money on re-painting the apartment, buying new furniture or re-modelling. This expense is estimated to be anywhere between 2%-4% of the selling price.

You won’t need to spend money on Capital Expenditure when it comes to selling.

Keeping all the above factors in mind, here is the bottom line in terms of net present value of all projected cash flows over the 3-year investment horizon:

Option 1: Ready Investment

Net Present Value* of 81,302 AED

Option 2: Off-plan Investment — 60/40 payment plan

Net Present Value* of 19,927

* a 7% discount rate is used for both calculations — the exact discount rate doesn’t matter as long as we are discounting both cash-flows by the same rate

From the above calculation, you can see that if you are purchasing an off-plan investment for a price that you can readily find on the ready market, the verdict is clear: ready beats off-plan [ an NPV of 81k >>> 20k]

Let’s assume you are purchasing the off-plan property for a 10% discount compared to the ready apartment for a purchase price of 720,000AED instead of 800,000 AED.

This time instead of a 60/40 payment plan, we are going to assume a much more lenient payment plan of 30/70, here is how the new numbers will look:

Option 2: Off-plan Investment — 10% discount and 30/70 payment plan

NPV 109,909 AED

The numbers now show that the off-plan investment is a more lucrative decision (110k > 81k)

This is mainly due to the fact that cash payments have been pushed further into the future with minimal amounts paid in the first 2 years.

You can achieve a similar tactic when investing in ready units if you choose to make use of debt by leveraging your investment.

Here is how the numbers would then look for the ready apartment if you place a 25% down payment and take a mortgage for the rest of the amount for a loan term of 25 years with an interest rate of 4%

NPV 104,528 AED

Choosing to finance the ready apartment purchase with a mortgage does increases your net present value from 81k to 104k.

This makes the investment almost as attractive to the off-plan investment from a pure numbers perspective.

A final word

As attractive as 30%[construction phase]/70%[upon handover] plans or 30%[construction phase]/40%[upon handover]/30%[post-handover] or 20%[construction phase]/80%[upon handover] payment plans seem to be there are a couple of things to keep in mind.

• Most probably the developers offering these payment plans are still fresh in the market trying to gain a competitive edge. Mature developers like Emaar do not offer these attractive payment plans, just for the sole reason that they don’t need to do so to attract buyers. Their reputation speaks volumes.
• There is an inherent financial risk in investing in low down-payment plans. A lot of buyers jump in thinking: All I need is to figure out the funding for 20% or 30% of the purchase price and then when the construction is completed I’ll take out a mortgage to fund the rest of the amount.
• But it is quite the common case that a lot of these same buyers might be in a worse financial position 2–3 years from now and might not be eligible for a mortgage, or won’t be willing to plunge further into debt. What happens is a run-on sale where many buyers compete to sell their off-plan investments before the handover payment is due, driving prices down.

Other off-plan risks to keep in mind are scheduling risks. It is very common for projects to get delayed. If a project is delayed for a year, that is one additional year when you could have been generating cash-flow through your ready apartment.

Another thing to note is that in our above calculations, rent was only increased at a 2% rate. If rents rise faster than this rate then the case for investing in a ready apartment just got stronger.

Same goes for the discount, we only assumed a 10% price advantage over a ready apartment. If, however, you can find an off-plan property that is likely to be at least 20% lower in price than the best deal you might find on the ready market, then the case for investing in off-plan just got stronger.

In conclusion, take the time to properly assess any ready or off-plan investment. Keep in mind the intangible factors at play as well, or try to add this as a contingency in your calculation in some type of way.

Always be conservative in your estimates. Go through the numbers the same way we did, and be ready to analyze many deals before you settle on the right decision.

Do what Billionaire Dan Gilbert Did: “Buy Up Detroit after the housing market crash”

Buy low and sell high. This should be your mantra when investing. You will need to be far-sighted and up to date with the most recent changes and events in the market. Most importantly you must be aware of the mechanics behind Dubai’s real estate cycle.

“What goes up must come down” — as true as this saying is when speaking about the laws of gravity, it is as prophetic when describing the real estate cycle.

History does repeat itself in real estate and it is mostly due to our innate human behavior. An irrational exuberance almost always builds up, fueling prices to very high and risky levels (unsupported by personal income and rental levels), which always leads to a market ‘correction’ driving prices back down.

The real estate cycle consists of four main phases: “ Recession, Recovery, Expansion, Hyper Supply”.

To help explain the cycle, let’s do this quick exercise. Assume you have a time machine, which year would you rather visit to make your first real estate investment in Dubai — 2012 or 2015?

To freshen your memory here is how things looked back in early 2012:

• Construction Supply in Dubai was at an all-time low
• Oil prices were fairly stable, fluctuating between a minimum of 80–105 dollars a barrel.
• Job growth showed promising positive signs with an increasing rate of new business formation
• Real Estate prices were stable and had already bottomed out mid-2011
• Rental levels were just bottoming out
• Rental Yields were much higher than the long-term equilibrium levels

Here is how things looked back in early 2015:

• Oil prices were cut by more than half
• Job growth was negatively impacted; especially in the oil and gas sector.
• Construction supply was at an all-time high since 2012, with developers delivering 6,399 buildings in 2015.
• Real Estate prices were already lower than late 2014 levels
• The rate of increase in rental levels started slowing down back in late 2014
• Rental Yields were much lower than the long-term equilibrium levels

Clearly purchasing a property in 2012 would have been a much better bet than having jumped in the real estate game in 2015.

Come 2012, the Dubai real estate market had previously undergone the worst financial crisis it has ever been (late 2009–2010). Following the recession, the market went through a recovery phase in 2011–2012, which for any savvy investor would have been the perfect time to buy.

“When the supermarket has a sale, say on toilet paper, the consumer runs in and stocks up. But when the housing market has a sale, most often called a crash or correction, the same consumer often runs away from it.” — Robert Kiyosaki, Author of Rich Dad Poor Dad

Below is a chart of Dubai’s Real Estate Cycle.

Dubai’s mojo back in 2013 was hugely boosted by the announcement of the Expo 2020, growth was blown out proportions and the market bubbled with no intrinsic explanation given the fundamentals at the time.

Post-2014, a significant drop in oil prices and the continuous strengthening of the dollar lead to a major loss in the purchasing power of Emiratis, Saudis, Brits, Indians, and Pakis. This huge drop in foreign investment combined with job loss, low rental yields, and a surplus in supply drove real estate prices down to the levels they are at today in 2017.

For those wondering if we have hit rock bottom yet in 2017, or if a further spiral down in rental levels will place pressure on rental yield levels and push prices down a bit further — the answer is a bit more complicated.

You will need to examine each submarket on its own. The demand drivers for affordable housing are completely different than those behind luxury properties.

For instance, a lot of the jobs, that will be created for the expo 2020, will more likely drive a much greater demand in affordable housing than in luxury properties. Redundancies appear to have hit the high-income segment hard and job growth is concentrated in the middle-income segment, which will shift end-user demographics.

You will need to carefully assess price and rental trends in the area of interest, the potential for future supply, any planned infrastructure projects, and overall demand for the asset class you are exploring.

On a more general note, considering price levels have remained fairly stable over the past year and will likely remain so before going into 2018, I do recommend you start looking for a property to buy and catch the wave before a sprint in prices is due.

As of today, you can certainly find solid values in the Dubai real estate market. Look for solid value in your deals and do not bet on price appreciation alone to justify your investment decision.

Whether you are already operating a rental property or looking to invest in one, you need to know what your property’s cash flow potential is. Three key figures to look at to assess your current cash flow are your property’s Cap Rate, Cash on Cash Return on Investment (CoC ROI) and the Debt to Cash Ratio (DCR).

We are going to take the example of a traditional 1 bedroom apartment rental property in Lakeside Tower C in IMPZ, Dubai. We will go through the process of generating these metrics step by step so you can easily repeat the same calculation for your property of interest.

A little bit about our sample investment:

Community: IMPZ

Building: Lakeside Tower C

Beds: 1 bedroom

Size: 680 SqFt

Purchase Price: 600,000 AED*

Total Service Charges: 12 AED/ Sq Ft

Expected Rent: 50,000 AED/year

* The purchase price in our case excludes all closing costs (property registration fees, mortgage valuation fees, processing fees, registration fees, agent fees, and other relevant fees).

Step 1: Calculate your Annual Gross Income

This is the total income you will be generating from your investment. This is mostly the rental income produced. Now in case you were creative and re-purposed your property as a holiday home or an employee rental, you might be able to maximize this income significantly.

Example: If we are planning on operating our apartment the whole year long, then our annual gross income in our case is simply equal to the expected rent of 50,000 AED

Step 2: Calculate your Annual Vacancy Costs:

This is the money value of the total number of days that your property will be vacant, in other words: not generating revenue. Operating your property as a traditional rental with a year-long tenant will lower your vacancy rate. While choosing to rent out your property as a holiday home using Airbnb, for instance, will most likely mean a much higher vacancy rate as there will be days that you will be looking for a new tenant to move in.

Example: If we will spend around a month looking to find a tenant to move in and occupy our apartment, then our vacancy will be the opportunity cost of having our apartment unoccupied for 30 days. Vacancy = 30 days/365 days x 50,000 AED/year = 4,110 AED

Step 3: Calculate your Annual Total Operating Expenses:

As a landlord, you will have to manage your own property but also you will need to contribute to maintaining your building’s common areas ( gym, swimming pool, building equipment, building facades, air-conditioning units, elevators, chillers, water tanks, fire pumps).

Even if you choose to manage the property yourself and not go with a property management firm, you will still have to take into account the monetary value of your time. Property management companies usually take around 5–8% of your rental income to manage and operate your asset.

As for your common area service charges. You will have to chip in every year by an amount agreed upon by your building’s owners’ association. Each landlord will have to pay a unit cost on an AED per Sq Ft basis. This means the larger the unit you own as a landlord, the larger the service charges you will need to pay.

The building’s service charges will most likely depend on the company your building’s owner association ends up choosing to take care of the following:

• Insurance
• Maintenance
• Management
• Services
• Utilities (chiller, DEWA, district cooling)

You will also need to contribute money to your building’s Sinking Fund. A sinking fund is a reserve fund set up to cover capital investment/expenditures, such as replacing assets in common areas. In Dubai expect to place anywhere between 2%-10% of the total charge fees into the sinking fund. The older the building, the bigger the sinking fund bill should be as assets start to deteriorate.

Additionally, you might have to pay extra costs like parking costs in certain cases.

Service charges are agreed upon by the building’s owners’ association so you do have a say in them through democratically electing the building committee and through expressing any concerns to the committee members.

Keep in mind service charges are regulated and are expected to be in line with the service charge index set by the Dubai Land Department.

Example: The apartment we own is a 680 Sq Ft unit located in a building where the total service charge fee is 12 AED/Sq Ft, then the annual service charge fees or total operating expenses will be: Total Operating Expenses = 680 Sq Ft x 12 AED/sqft = 8,160 AED.

Step 4: Calculate Your Net Operating Income (NOI)

Your net operating income is what you take home after paying all operating expenses, property taxes (doesn’t apply in the case of Dubai) and discounting vacancy days.

NOI = Gross Income — Vacancy — Expenses

Example: Let’s do the annual NOI calculation for our 1 bedroom apartment. We previously calculated our gross income as 50,000 AED, our vacancy costs as 4,110 AED, and our total operating expenses as 8,160 AED.

The NOI therefore will be NOI = 50,000 AED — 4,110 AED — 8,160 AED = 37,730 AED.

Step 5: Calculate the Capitalization Rate (Cap Rate):

After going through the above four steps, we can now calculate our property’s purchase cap rate.

The property’s purchase cap rate is the ratio of the net operating income to the purchase price. The cap rate is a metric that is completely independent of the buyer and the details of the financing. It is always a great exercise to benchmark your property’s purchase cap rate to the median market cap rate. It is a quick way to evaluate how big or small the cash flow you are currently producing is compared to the market.

Cap Rate = NOI/Price

Example:

If we had purchased the property for 600,000 AED and our NOI is 37,730 AED then our cap rate calculation is simple:

Purchase Cap Rate = 37,730 / 600,000 = 6.28 %

A 6.28% cap rate is lower than the median cap rate you could readily get in certain communities in the Dubai market, so overall this is our first negative indicator.

Step 6: Calculate Your Annual Debt Payment:

There are multiple types of mortgages in the market. However, for the sake of simplicity, we are going to assume a conventional fixed rate mortgage.

With a fixed rate mortgage, you will be expected to make fixed mortgage payments on a regular basis. The mortgage amount is based on the loan to value ratio (LTV) that you end up agreeing on with the bank. The mortgage is then amortized over a long-term (in Dubai the usual is around 20 years) at a certain interest rate (around 4%).

Mortgage payments are amortized. This means that early on, most of the payment goes towards repaying the interest on the loan, and later on the payments mostly go towards making principal payments on the loan.

To calculate your debt payment, here is the formula you will need:

Debt Payment = Debt First Year * (i * (1+i)loan term)^(1+i)/((l+i)^loan term-1)

Where

• Debt First Year = ( LTV Ratio / 100) * Purchase Price
• i = loan interest / 100

Example: In our case, let’s assume you took out a loan with a 75% LTV, amortized over 20 years for an annual interest rate of 4%.

You will need to be making monthly payments to your lender (bank) so in this case, you will need to be making a total of 20*12 = 240 payments [your loan term = 240 months], your monthly interest rate will be 4/12 = 0.33% per month

Debt First Year = ( LTV Ratio / 100) * Purchase Price = 75/100 * 600,000 = 450,000 AED

i = loan interest / 100 = 4/100 = 0.0033

Debt Payment = 2,727 AED/month

This will amount to an annual payment of 2,727 AED/month * 12months/year = 32,724 AED/year

Step 7: Calculate Your Free Cash Flow

The free cash flow is defined as the net operating income minus any debt payment. In case you chose to pay for your investment fully in cash then your cash flow is equal to your NOI.

Free Cash Flow = NOI — Debt Payment

Example: The free cash flow is simply our NOI which is 37,730 AED minus our Debt Payment which is 33,112 AED. Free Cash Flow = 37,730 AED — 32,724 AED. = 5,006 AED

Step 8: Calculate The Cash on Cash ROI (CoC ROI)

The cash on cash return on investment is the ratio of your free cash flow to the equity you invested. The cash on cash ROI depends on how you, as a buyer, chose to finance your investment. The larger of a loan you take, the smaller your free cash flow, but also the smaller your initial equity.

CoC ROI = Free Cash Flow / Equity

Where Equity = Initial Down Payment + Closing Costs

Example: In the case of our 1 bedroom apartment, our initial equity = Initial Down Payment + Closing Costs

Initial Down Payment = 25/100 * 600,000 = 150,000 AED

Closing Costs = 7/100 *600,000 = 42,000 AED (closing costs for a ready property are around 7% in Dubai)

Equity = 150,000 AED + 42,000 AED = 192,000 AED

This makes our first year cash on cash ROI = 5,006 AED / 192,000 AED = 2.6%

As a note some banks in Dubai cover 25% of the closing costs in the mortgage, this will slightly improve our cash on cash ROI but overall our CoC ROI is still lower than the median CoC ROI you can find in the Dubai Market.

Step 9: Calculate the Debt Coverage Ratio (DCR): To calculate DCR, take the NOI and divide it by the annual debt. A property that achieves a 1.2 DCR is simply generating 20% more income than the payment of the debt.

DCR = NOI / Debt Payment

The DCR is a basic, yet effective indicator that shows how leveraged you are. The closer the DCR is to 1, the riskier the investment is, since any unexpected expense or shortcoming in terms of rental income and you will dip into the negative, having to dig deep into your own cash to make your bank payments.

Example: In our case, our NOI is 37,730 AED, and our Debt Payment is estimated around 32,724 AED. Then our DCR is equal to 37,730 AED/ 32,724 AED = 1.15

Step 10: Assessing Your Cash Flow

Now that you have calculated our 3 key metrics (Cap Rate, Coc ROI, and DCR), let's take a step back and evaluate these numbers.

It is clear that from a cash flow perspective that this investment is not performing so well. Here are three general recommendations you should keep in mind when investing in a rental property for cash flow in the Dubai Real Estate market:

• Aim to purchase rental properties with at least an 8% cap rate.
• Aim to earn at least a 10% cash on cash (COC) return from day one. Buying with an actual 10% COC limits your downside risk, and any forced appreciation that occurs on the property will become your profit.
• Aim for at least a 1.3 Debt Coverage Ratio (DCR) in case you decided to take a mortgage to finance your investment.

In our case, you will have to negotiate the price down from 600,000 to at least 470,000 AED, or you will have to get creative and increase your rental income from 50,000 to 62,000 AED to make this an attractive rental property investment.

“Profits in real estate are made in the buying, not in the selling.” — Robert Kiyosaki

Don’t rush the buying process. I can’t stress this enough. Do your due diligence and evaluate your investment properly.

In this article, I am going to show you the two main ways of making money from a ‘ready’ investment. By ‘ready’, I mean a property that is completed and no longer under construction.

The two avenues of generating returns through real estate investing in Dubai are clearly defined. However, as basic as it might be, a lot of buyers still jump the boat, fall in love with a property and invest blindly.

Don’t commit the mistake of falling in love with a deal. Fall in love with the numbers.

Don’t get carried away by a sales agent who is rushing you to close a deal. The sale agent’s role is to create a hype, to show you that the property is already wanted by a gazillion other buyers.

There are 5,000+ real estate agents in Dubai and they are all rushing to sell around 3,000 deals every month. Competition amongst them is crazy.

Your role is to stay calm and assess your deal carefully.

Now that you have been warned, here are the two main ways of making money from your real estate deal:

1. Making profit from a price gain
2. Generating cash flow through rental income.

Let’s discuss each in more detail.

1. Making profit from a price gain:

There is more than one way to guarantee a “price gain” but basically it boils down to two routes :

1. Buying a property with a great potential for capital appreciation (i.e. a property who you think will be worth much more in the near future or your investment timeline).
2. Buying an underpriced property relative to its current market value

When it comes to betting on your selected property to appreciate in price, you will have to take into account both macroeconomic and local trends. You will need to be aware of certain indicators behind the price movement of your asset class in the specific community of interest. I suggest you become familiar with the relevant real estate dynamics and the overall real estate cycle in Dubai.

You shouldn’t rely solely on market price appreciation if you want to convince yourself of a good deal. Instead, you should look to buy a property that is currently underpriced relative to its market value as well.

As Warren Buffet says: “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”

Purchasing an underpriced property already guarantees you are at a price advantage, regardless if prices are going to increase in the future. It also gives you a nice price cushion if prices start heading downhill.

So how do you know if you are buying an underpriced property?

1. Find comps (short for comparables) which are similar properties with a similar size, floorplan, number of bedrooms/bathrooms, amenities, floor level, and view, that have recently sold in the same community or building cluster.
2. Adjust the prices for each positive or negative feature of the comps relative to the subject property. Through this detailed and systematic comparison, you would have adjusted for positive and negative property differences.
3. Estimate the market value of the subject property from the adjusted sales prices of the comps.

As a rule of thumb, aim to find a property that is priced at least 10% below market and try to negotiate the price down another 10%. Keep in mind you will have to pay up to 7% of the purchase price as closing costs so negotiating at least 10% down is a must.

2. Generating cash flow through rental income

To analyze the cash flow of a property, you will need to have the following inputs:

• Financing — Are you going to take a mortgage/loan to finance this investment?
• Procurement — What are all the closing costs you will need to pay when buying?
• Operations — What are your expected rental income, vacancy, and total operating expenses?

One thing to really emphasize here is data. You will need to make your own due diligence in making sure the data you collect is accurate.

Gathering accurate data can often prove the difference between making the property look great on paper, and horrible. Don’t underestimate your costs, or overshoot your expected rental income. Be conservative in your estimates.

Once you have done your homework, here is what you should look for:

• In the Dubai market, aim to purchase rental properties with an 8% cap rate
• Try to earn at least a 10% cash on cash (COC) return from day one.
• Aim for at least a 1.3 Debt Coverage Ratio (DCR) in case you decided to take a mortgage to finance your investment.

Final Word

Out of these two ways of profiting from ready investments, there has emerged two types of investors. Those who seek to make the money mostly from a price gain (equity investors) and those who place more value in the cash returns of the investment (cash flow investors).

One good recipe is to be a bit of both. Finding an underpriced property with a decent cash-flow potential is a solid strategy when trying to invest in rental properties.

In numerical terms, your total return on investment will be the sum of your expected price gain and your total cash on cash return on investment. You could also use slightly more sophisticated metrics like the net present value (NPV) and internal rate of return (IRR) as bottom-line metrics to assess your investment’s return potential and make a well-informed decision.

Get ready to analyze many deals before landing on an investment!