How much money can I make investing in UAE real estate? Let’s find out how to calculate profits

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Dubai Silicon Oasis. Confidence in the UAE’s real estate sector began to grow last year but was boosted last November when Dubai was successful in its bid to host Expo 2020. Image Credit: Zarina Fernandes/ Gulf News

Dubai: Investors from across the globe looking to invest in real estate see the UAE as one of the most lucrative of destinations. The property market has grown its attractiveness both among the new and seasoned investors.

The place offers higher profits on your investment, otherwise known as return on investment or ROI, compared to several established global property markets, experts evaluate.

Most business entrepreneurs in the UAE invest in Dubai since they can reach gross rental yields between 5 and 9 per cent, which makes the city an affordable location to own a property, evaluates Marwan Al Sheikh, chief executive officer (CEO) at Dubai-based Medait Star Real Estate.

“On average, the rate of return in real estate mostly ranges between 8 and 10 per cent globally. Dubai is more open to inviting investors compared to Abu Dhabi, so the rate differs. The average rate of return for Abu Dhabi stands at 4 to 6 per cent annually.”

Why understanding the ROI is an essential part of any investment?

ROI stands for return on investment that measures profit margins on investments. Sheikh stated that ROI is vital to indicating how productive and sufficient capital is used to multiply profit.

“It gives you the knowledge or idea, once calculated, whether an investment is a potential asset or a liability, or if it will be a gain or loss. This also gives an investor a rough estimate of which type of asset is more profitable and whether it is worth investing in the first place.”

In brief: What is ROI in real estate?

ROI in real estate is used to evaluate the annual return of an income-producing property and the final return made when selling a property.

“ROI is a useful performance metric to compare the efficiencies of several different investments,” said Zhann Jochinke, chief operating officer (COO) at Dubai-based market analytics firm Property Monitor.

“It can be utilised to quickly compare investment opportunities both within and in comparison to the housing market. ROI allows you to focus on the return you get on your cash regardless of the investment size.”

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Not everybody’s expectations of ROI is the same

Not everybody’s expectations of ROI is the same

Jochinke further explains that one investor’s ROI expectations might differ with another’s due to two main factors:

Operating expenses they choose to incur. For example, using or not using a professional property manager, the level of repairs (does the investor pay for a short term repair or do they invest in a longer-term replacement, like in the case of air conditioner units in villas)

• The mortgage or possible borrowing options they have at their disposal and take advantage of. For example, do they pay all cash, or do they take the highest amount of financing available, or are they able to take out an interest-only loan.

Different ways to calculate your return on investment (ROI)

There are many different methods used to calculate ROI.

Among others, ‘cap rate’, ‘cash-on-cash returns’ and ‘internal rate of return’ (IRR) are the most used practices to assess an investment, and the investor should know the pros and cons of each, notes Ayman Youssef, vice president at Dubai-based real estate agent Coldwell Banker UAE.

• How to calculate ‘Net Rental Yield’ or ‘cap rate’?

He pointed out that the net rental yield, also called the cap rate, is the easiest way to calculate ROI when buying real estate in cash.

“It is calculated by dividing the annual income of the property by the total cost of buying it. A common mistake here is not to include the running cost of the property and the total acquisition cost in this calculation, which can end up giving you misleading numbers.

“Running cost includes any operational costs like service charges, maintenance or repair costs, property management fee if you decide to give your property to a property management company to manage.

“Total acquisition cost is the purchase price as well as all the transaction costs that involve 4 per cent Dubai Land Department (DLD) fees, 2 per cent agency commission and any other administrative fees,” he added.

FORMULA: Net Rental Yield is calculated using this:

Net Rental Yield = [(Annual rent – Annual running expenses) ÷ Total Acquisition Costs] x 100

Illustration with calculation: For a cash buyer looking to buy a property worth Dh1 million:

Total Acquisition Cost = Dh1,066,280 – Here’s the breakdown:

• Property Price = Dh1 million

• Dubai Land Department Fee (4 per cent of the property value + Dh580 admin fee) = Dh40,580

• Real Estate Agency Fee (typically 2 per cent of the property value + 5 per cent VAT) = Dh21,000

• Trustee office fees = Dh4,200

• Fee for No Objection Certificate (NOC) to transfer property ownership = Dh500

Expected Annual Rent = Dh60,000

Annual Running Expense = Dh12,000 – Here’s the breakdown:

• Service charges = Dh 10,000

• Other operational costs = Dh 2,000

Now, let’s apply the above figures to the mentioned formula for Net Rental Yield: i.e,

Net Rental Yield = [(Annual rent – Annual running expenses) ÷ Total Acquisition Costs] x 100

So, Net Rental Yield for the above cash buyer = [(60,000 – 12,000) ÷ 1,066,280] x 100 = 4.5 per cent

Youssef further explained that the net yield does not apply to the buyer purchasing via financing (known as a ‘finance buyer’) or loans as it doesn’t consider the mortgage or home loans. Therefore, the cash-on-cash model is best suited to get a snapshot of your investment for the current market in the case of such a buyer.

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For calculating cash-on-cash return, divide the property’s annual cash flow by the amount of money you paid to acquire it.

• How to calculate ‘Cash-on-Cash’ return?

“For calculating cash-on-cash return, divide the property’s annual cash flow by the amount of money you paid to acquire it. That includes closing costs, property improvements you paid for, and other expenses incurred when purchasing the property.”

FORMULA: Cash-on-Cash return is calculated using this:

Cash-on-Cash return = (Cash income earned ÷ Cash invested in a property) x 100

Illustration with calculation: For a finance buyer calculating on the cash-on-cash model:

Property Price = Dh1 million

Total Cash Investment = Dh273,565 – Here’s the breakdown:

• Down payment (if 20 per cent of property value) = Dh200,000

• Dubai Land Department Fee (4 per cent of the property value + Dh580 admin fee) = Dh40,580

• Registration Fee (4,000 Dh for properties over 500,000 + 5 per cent VAT) = Dh4,200

• Mortgage Registration Fee (0.25 per cent of the loan amount + Dh 10 admin fee) = Dh2,010

• Real Estate Agency Fee (Typically 2 percent of the property value + 5 per cent VAT) = Dh21,000

• Bank Arrangement Fee (0.25 per cent of the loan amount + 5 per cent VAT) = Dh2,100

• Valuation Fee (Between Dh2,500 and Dh3,500 + 5 per cent VAT) = Dh3,675

Expected Annual Rent = Dh60,000

Annual Running Expense = Dh12,000 – Here’s the breakdown:

• Service charges = Dh10,000

• Other operational costs = Dh2,000

Mortgage Instalments = Dh36,000 (If EMI is Dh3,000, annually you will pay = Dh36,000)

Cash Income earned = Annual Rent – Running Expense – Mortgage

therefore, Dh60,000 – Dh12,000 – Dh36,000 = Dh12,000

Now, let’s apply the above formula to calculate the cash-on-cash return.

Cash-on-Cash return = (Cash income earned ÷ Cash invested in a property) x 100

So, Cash-on-Cash return for a finance buyer = (12,000 ÷ 273,565) x 100 = 4.4 per cent

Youssef added that although the net yield gives a snapshot based on the current market, there are some limitations as it does not include the future projected cash flows (cash being transferred into and out of a property) and the selling price of the property at the end of the investment horizon (time period or term).

For instance, there is an office lease contract with an annual rate of increase of 5 per cent, and the first year rent is Dh100,000. Next year, the rent will be Dh105,000, the year after will be Dh110,250.

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Investing in a property in the UAE requires dedicating time for research and knowing just how much you can finance. Image Credit: Shutterstock

• How to calculate ‘internal rate of return’ (IRR)?

Therefore, for cases where you need to evaluate the variable future cash flow, the internal rate of return (IRR) method is used.

“IRR is the expected compound annual rate of return that is earned on a project or investment. It’s a similar concept to the previous model, but it’s compounded over time. So you are evaluating the investment option over some time, considering how the asset price will perform over time and how much it can be sold for.”

In generally, IRR is used by most investors as a way to compare different investments, Youssef said. “The higher the IRR, the more desirable the investment. IRR is one of, if not the most important measure of the profitability of a rental property.

“It is calculated using the IRR function in Microsoft Excel, where you enter your stream of costs and benefits. The IRR includes the future value of money and opportunity cost.”

What is internal rate of return (IRR) and why is it important?

The internal rate of return (IRR) is a financial metric used to assess the attractiveness of a particular investment opportunity. When you calculate the IRR for an investment, you are effectively estimating the rate of return of that investment after accounting for all its projected cash flows together with the time value of money.

When selecting among several alternative investments, the investor would then select the investment with the highest IRR. The main drawback of IRR is that it is heavily reliant on projections of future cash flows, which are notoriously difficult to predict.

Youssef stated that net yield is usually suitable for ready properties when there is no variation in your future cash flow. IRR model is more reliable to get a bigger picture of all the investment opportunities available, he explained.

FORMULA: Internal rate of return (IRR) return is calculated using a fairly complex Microsoft Excel Function/Formula for ‘IRR’

Illustration with calculation: For a finance buyer and a cash buyer based on the IRR model:

Property cost = Dh1 million

Investment period = 10 years

Expected sale price of the property after 10 years = Dh1,280,000

Assumed discount rate = 7 per cent (discount rate reflects risks, opportunity costs and other factors affecting the value of your investments)

Case 1: Let’s assume the following instance of a person who buys a property with loans (a finance buyer) and calculate what the IRR rate will be:

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Image Credit: Supplied

So in this case, IRR rate for a finance buyer = 11.1 per cent (which is derived from the Microsoft Excel function)

Case 2: Let’s assume the following instance of a person who buys a property with cash (a cash buyer) and calculate what the IRR rate will be:

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Image Credit: Supplied

So in this case, IRR rate for a cash buyer = 6.4 per cent (which is derived from the Microsoft Excel function)

From these examples you can see that cash buying has a lower IRR than a finance buying, so we can safely say in this particular case, considering finance is a better option for the investor. You can also use the same methodology to calculate and compare the IRR for different properties. The higher the IRR, the more desirable the investment.