Knowing how to evaluate properties and creating an accurate picture of your investments is an integral component for any real estate investor or firm.
As we all know, real estate can be a very lucrative vehicle to earn extra income, replace your 9-5 and build a great financial foundation for you and your family. However with any investment you make, you expose yourself to a certain level of risk. With risk comes fear and fear is one of the main reasons why individuals prolong investing.
With that being said, there are multiple ways to mitigate your risk and increase your odds of a successful investment. There are certain calculations that will determine if you should move forward with an investment or continue searching.
Everybody always wonder's what to do when you are looking for properties to invest in? How do you know if this is the property that you should pull the trigger on and invest your hard earned money into. As a real estate investor, you should have a specific criteria that will determine if and when you invest. Within this criteria, the most important determinant will be the numbers.
People tend to make the concept of investing in real estate more difficult than it really is. In reality it can be fairly simple and if you understand basic math, then you should have no problem with evaluating a property.
What are the 2 most important results any real estate investor looks for? Cash Flow and Equity. What determines your cash flow on a property? Income and Expenses. What determines your equity? What you purchased the property for compared to what it's full value is. (discounted purchase
So if you are considering investing in real estate, please take the time to learn some simple calculations to increase your odds of a good investment.
Calculations To Produce Solid Real Estate Investments
Now that you understand that the numbers involved in a real estate investment are the most important criteria to be successful, lets discuss some of the key terms and concepts you need to know in order to evaluate a rental property.
1) Gross Operating Income - Maximizing your rent and other sources of income is very important for your rental property investment.
Gross operating income is the total amount of income produced through rent and other sources (coin operated laundry) minus vacancy and credit loss.
Here is a simple way to go about calculating the gross operating income of a property.
Gross Scheduled Income
- Vacancy and Credit Loss
+ Other sources of Income
= Gross Operating Income
I can hear you now. What is gross scheduled income, vacancy and credit loss. Well lets discuss them quick, they are easy to understand terms.
Gross Scheduled Income - This is the total amount of rental income that you will expect to receive if your property is fully rented for 365 days a year.
Vacancy Loss - The loss of income resulting in tenants either not paying their rent or turning over a unit.
Credit Loss - This number will be much less than vacancy loss and may not apply to your properties but it still needs to be added. It is the result of checks not arriving or clearing in the bank. (believe me it happens)
The vacancy and credit loss on a specific investment will vary. Each farm area will be exposed to lower or higher vacancy rates. Understand your market and use a conservative estimate when evaluating your rental properties. A common percentage used throughout the industry is 10% but as stated this number will vary depending on your location.
2) Net Operating Income - This will be used as a profitability formula to determine your expected profit on a property, not taking into consideration debt service. In other words this formula will help determine your expected cash flow on a property (not taking into consideration monthly mortgage payments)
Net Operating Income is the annual income produced from a rental property minus all operating expenses that you incur while holding your property (besides mortgage payments)
Not only is this a valuable calculation for real estate investors but lenders and banks will use this calculation to determine whether they should issue a loan on the property or not.
So how do we arrive at the Net Operating Income? The formula is also fairly simple.
Gross Operating Income
- Operating Expenses
= Net Operating Income
The reason this calculation can be somewhat difficult to predict is due to accurately acquiring the operating expenses for any given property. The fact is that most landlords severely underestimate the costs of operating a rental property.
Here are some potential operating expenses that you should consider during your evaluation:
Repairs and Maintenance
These are the most popular operating expenses that you have the potential to incur throughout the life of owning a rental property.
3) Cap Rate - The return on investment is an important figure that all real estate investors consider when making a purchase. Your ROI evaluates how much money was made on your investment as a percentage of the purchase price. This number is equivalent to the return on investment you would see if you were to pay all cash for a property.
Cap Rate (Capitalization Rate) is the ratio between the Net Operating Income and the properties value (price).
This is also a calculation that lenders, banks and appraisers will use to evaluate an assets value.
The formula we use to determine cap rate is:
Net Operating Income
/ Properties Price
= Cap Rate
However, this calculation will only give you your potential ROI on a property that was purchased in cash. If you plan to take a mortgage out on a property, you will have to account for a few more steps to generate your ROI.
Calculating the ROI on a property where a mortgage will be held will be referred to as a Derivative Cap Rate
In order to accurately calculate this formula you will need to know the terms of financing available to you along with the return you would like on your investment.
This formula is a bit more complicated but needs to be discussed if you intend on using lenders to leverage your portfolio.
Lets first start off with the terms of financing. We need to determine the loan constant or (mortgage constant). This loan constant multiplied by the loan amount will produce the payment needed to fully pay off your debt over the life of the loan.
So what the hell is a loan constant. In laymen terms, it is a factor of interest used to determine your complete debt payment over the life of the loan.
This loan constant is calculated by:
Annual Debt Service (monthly mortgage payments x 12)
/ Loan Principal Payment
= Loan Constant
Lets go over an example.
You are looking for a loan of 75% of the total property value of $100,000 ($75,000) over a 30 year period on your first rental property.
You find a lender that is willing to lend you that $75,000 over 30 years at an interest rate of 5.0%.
Your annual debt service or your interest and principal payments for the first year will be $4,832.
Your Principal Loan Payment is $75,000.
4,832 / 75,000
So using the specific financing terms on the loan being issued, your loan constant will be .064427.
So now that we have figured out the terms of financing for your first project, we will need to now calculate the return on your equity.
We first need to determine the cash return that you expect from your investment. Let's say that you require 20% pre-tax return on your investment.
Since you are getting a loan for 75% ($75,000) of the full market value, you will be required to issues a down payment of 25% ($25,000).
Under these circumstances, your annual cash on cash return will be $15,000. ($75,000 x .20).
Ok, you may be thinking this formula is complicated, but read it over a couple times and it will click.
it is now time to put it all together.
Lets remember, the derivative cap rate is the return that we will expect when a mortgage is issued on a rental property.
The formula we will use to calculate our overall cap rate is :
(LTV Debt Ratio x Loan Constant) + (LTV Equity Position x Equity Constant)
= Derived Cap Rate
So lets finish the example on our first rental property. Using the mortgage terms discussed above and the 20% return that we require.
(.75 x 064427) + (.25 x .20)
(0.4832) + .05
To convert this decimal into a percentage we will need to move the decimal point 2 spots. This will result in a cap rate (return) of 9.83%
So for shits and giggles, lets say we wanted to find out the maximum purchase price on a property.
The Net Operating Income is $10,000. To find out an estimate around our maximum purchase price on the property, we will use this formula to calculate:
Net Operating Income / Derivative Cap Rate
$10,000 / 9.83
= $101,729.40 ( Maximum Purchase Price)
Going back to our example. $101,729.40 is very close to the asking price of $100,000.
Using your set criteria, does a 9.83% cash on cash return work for you? If so, go on an take a deeper look into this property.
4) Cash on Cash Return - Another way that passive real estate investors can calculate a return on their investment is the cash on cash return on a property. All investors are interested in the percent return they will receive from their investments annually.
Cash on cash return is the ratio of annual pre tax cash flow to the total amount of cash invested, expressed as a percentage.
Cash on cash return can be calculated through a simple formula:
Annual Pre - Tax Cash Flow (NOI - Debt Service) /
Total Cash Invested
= Cash on Cash Return
Lets run through a very quick example of what your first year cash on cash return will look like for the example property that you are investing in.
Our NOI from our example property is $10,000. We calculated through an amortization schedule that we will pay $4,832 in principal and interest payments in our first year.
So our annual pre tax cash flow = 5,168
or $10,000 - $4,832
= $5,168 (pre-tax cash flow)
Our total cash invested will be our required down payment on the investment. ($25,000)
property value ($100,000) - lenders loan amount ($75,000)
= Downpayment ($25,000)
So to calculate our cash on cash return for our rental property, we are looking at:
(5,168 / 25,000) x 100 = 20.6%
This percentage does not take into consideration any income tax results, reductions in loan principals or future cash flows. This is strictly an equation that will calculate your cash on cash returns (in terms of a %) for year 1.
5) Debt Coverage Ratio - The debt coverage ratio or (DCR) is an important concept for real estate investors and lenders.
So what exactly is the debt coverage ratio?
The DCR on a property is the Net Operating income / Debt Service. It measures the ability to pay the properties monthly mortgage payments from cash generated from rental income.
Another simple formula we need to add to our arsenal :
Net Operating Income
/ Debt Service
= Debt Coverage Ratio
This formula is very important to lenders because it is a big determinant of weather a lender will approve a loan on your rental property. They want to make sure that the cash you generate from your rental income will cover both your operating expenses and your mortgage payment. Most lenders require a debt coverage ratio of at least 1.25 - 1.35. This means that your rental income must bring in at least 25 - 35% more than your operating expenses. This ensures that there will be enough cash flow coming in over the life of the rental property to cover the lenders loan payments.
A debt coverage ratio of less than 1, indicates that the property does not generate enough cash flow to cover its expenses. A DCR of more than 1 indicates the the property will cash flow, therefore a property with a DCR of 1.35 indicates that the property will cash flow and have extra reserves of 35% more to cover the banks loan payments.
So in regards to our most recent example of your first rental property. We have a Net Operating income of $10,000 and debt service of $4,832. So our simple formula to calculate your DCR on this specific property will be as follows:
$10,000 / $4,832
So in this example our property will generate 2.069 times more cash (100.069%) to cover our debt service.
Obviously a lender will not issue a loan on a property that will not be able to generate enough income to cover the loan. For our example, our first rental property checks out, so we should have no problem getting our loan from a lender.
Wrap Up The Real Estate Investment Calculations
We now understand how important it is to understand specific real estate calculations to enhance our odds of a successful real estate investment. Please go back over and read this post a couple times, understanding these concepts and terms is very important to your real estate investing success. For each real estate property that you evaluate, let the numbers speak to you. Run your calculations and establish a specific criteria that you require to move forward with an investment. This will help mitigate your risk and allow you to build a sizable, profitable portfolio that can potentially replace your income, generate extra income and most importantly build that financial foundation for our families that we all seek.
As the great Fabolous stated " Money can't buy happiness, but it's a damn sure good down payment"
I hope that this post will help make you aware of the details that real estate investing entails and how important certain calculations are when determining if a real estate investment will be profitable or not.
In the comment section below, let us know what other formulas or calculations you like to use and if you have a formula that you lean on the most when making your real estate investment decisions.