Despite what many of us math-allergic folk would prefer, real estate investments do require some math. You have to know your real estate metrics to succeed! What’s a good investment? What’s a bad investment? If you don’t crunch the numbers, you’ll never know.
Luckily, most of the formulas are simple and straight-forward. In fact, if you can master the calculations below, you should be just fine.
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Capitalization Rate (Cap Rate)
Used for: Apartment complexes and large commercial buildings
Net operating income (NOI) / total price of the property
- NOI: $25,000
- Total price (purchase and rehab): $300,000
$25,000 / $300,000 = 0.083, or an 8.3 percent cap rate
Cap rate is primarily used to value apartment complexes and larger commercial buildings. It can be used for houses and small multifamily too, but operating expenses are erratic with houses—after all, you won’t know how often and how bad your turnovers will be.
Cap rate allows you to compare properties in a similar asset class with differing characteristics that make a direct comparison impossible. For example, let’s say you’re comparing two apartment complexes. Building A is a 100-unit apartment complex with 75 one-bedroom units and 25 two-bedroom units that average 750 square feet. Each unit has old, wooden windows and central air and heat, and the apartment complex has an onsite laundry room and a community swimming pool.
Building B is an 80-unit apartment complex with 20 one-bedroom units, 50 two-bedroom units, and 10 three-bedroom units averaging 900 square feet. Each unit has vinyl windows and washer/dryer hookups—but only a furnace and window unit air conditioning. There is no swimming pool, but each tenant has a carport.
Comparing Building A and Building B is much more difficult than comparing two single-family homes. Enter the cap rate, which takes the actual income those buildings produce, subtracts the expenses, and divides it by the total cost. This is a great tool for comparing large assets, as long as they are in a relatively similar class and location.
Look for a cap rate that equals or exceeds that of comparable nearby buildings. Personally, I aim for an eight percent cap rate or better, although that’s impossible in some areas. Always be sure to use real numbers or your own estimates when calculating cap rate. Do not simply use what’s on the seller-provided pro forma—or, as I call them, pro-fake-a.
The disadvantage is that a cap rate is only a snapshot. It says nothing about the expected growth in rents, expenses, or property value. It also says nothing about whether using leverage will increase your return.
Used for: Rental properties
Total income – total expenses
- Monthly rent: $1,200
- Monthly expenses: $1,000
$1,200 – $1,000 = $200 monthly net cash flow
When evaluating rental properties, it’s essential to work out ahead of time your expected monthly cash flow. And you’ll need to look at the big picture—not just the simple numbers. After all, it’s easy to subtract your mortgage payment from the rental income and think, “Ta-da! Positive cash flow!”
Not so fast. When determining your total expenses, make sure to include things like:
- Property taxes
- Hazard insurance
- Flood insurance
- Property management
- General maintenance and upkeep
- Capital expenditures
- Vacancy rate.
Need help sorting out cash flow? Check out our rental property calculator.
Return on Investment
Used for: Understanding how well a deal performed
Gain on investment – cost of investment / cost of investment
- Investment: $100,000
- Gain: $150,000
($150,000 – $100,000) / $100,000 = 50 percent return on investment
Return on investment is beneficial for analyzing how well a deal did in the past. This type of measurement is always important: You can’t fine-tune your future investing unless you know how your previous investments performed. Of course, when using ROI to analyze whether or not to buy a property, it’s only as good as your assumptions you put into it.
It’s important to look at this number in context. Looking at our example: 50 percent return on investment sounds great. But if it took you 50 years to make that kind of return, that’s not so great. You can get an annualized return on investment rate by simply dividing your ROI by the number of years you had the investment. In the above case, it would be 50 percent / 50, which equals a one percent annual ROI.
Internal Rate of Return
Used for: Getting into detail about how an investment performed
Pro tip: Calculating IRR is best left to a calculator.
Let’s say you are looking at a deal with the following assumptions:
- Purchase price and costs to close: $200,000
- Leverage: None
- First year net operating income: $20,000
- Annual growth rate of net operating income: 2%
- Year five capital improvements, such as a new roof or HVAC: $50,000
- Disposition price minus costs (end of year 10): $300,000
You can do this calculation in a spreadsheet using the formula =IRR() or you can use one of the many IRR calculators online, such as this one. With these numbers, you’ll find that your IRR equals 11.21 percent—before tax of course.
For the most precise evaluation of how an investment performed, we turn to the IRR. This can be a very powerful calculation, because it accounts for the variability of future cash flows—and for the fact that money invested sooner is worth more. Think about it this way: Would you rather have $10,000 today or five years from now? If you have the money now, you can invest that $10,000 and make a healthy return for five years. Thus, money now is worth more than money later.
So what the IRR is calculating is what your “annual effective compounded return rate” is, or in other words, what your average return is when taking into account when you have cash inflows and outflows.
Now here’s why this is important. Let’s compare that number we calculated to your ROI. The total of your return is $468,994. So if we calculate the ROI, we’ll find that it’s more than 2 percent higher than the IRR. What’s the reason? A large chunk of the money came in at the end, when the property was sold. As we noted above, money is worth more now than later, so your internal rate of return is reduced. The IRR accounts for when money comes in and out, whereas the ROI does not.
Learn more: Introduction to Internal Rate of Return (IRR)
Used for: Single-family homes and small multifamily properties
Monthly rent / total property price
- Monthly rent: $1,000
- Total property price (purchase and rehab): $75,000
$1,000 / $75,000 = 0.0133 or a 1.33 percent rent/cost
This is a great calculation for houses and, sometimes, small multifamily apartments. That being said, only use this calculation when comparing the rental value of like properties. Do not compare the rent/cost of a Class C property to one in a gated community. A roof costs the same, square foot for square foot, in both areas, but vacancy and delinquency will be higher in a bad area. Here, rent/cost won’t tell you what your actual cash flow will be. But when comparing like properties in similar areas, rent/cost is a very helpful tool.
According to Gary Keller in The Millionaire Real Estate Investor, the national average rent/cost is 0.7 percent. For cash flow properties, you definitely want to be above 1 percent. We usually aim for around 1.5 percent, depending on the area.
Used: For large portfolios
Annual rent / total price of property
- Annual rent: $9,000
- Total price (purchase and rehab): $100,000
$9,000 / $100,000 = .09, or a nine percent gross yield
This is basically the same calculation as above, but flipped around. It’s used more often when valuing large portfolios, but overall, it serves the same purpose as rent/cost.
It’s simple to calculate gross yield, which makes it a great back-of-the-napkin number. However, it leaves out so many variables, such as expenses and debt. It should only be seen as a shorthand tool and not an in-depth analysis.
Debt Service Coverage Ratio
Used: For obtaining financing
Net operating income / debt service
- NOI: $25,000
- Annual debt service: $20,000
$25,000 / $20,000 = 1.25 debt service ratio
Banks always want to see this important number, making it critical for obtaining financing. Generally, a bank will look at both the property’s debt service ratio and your “global” debt service ratio—that of your entire company or portfolio. In regular English, debt service ratio is a metric used to determine if you can afford to pay off your loans.
This metric matters because nine times out of 10, when you’re buying real estate, you use debt.
A debt service ratio below 1 indicates that you will lose money each month. Banks don’t like that—and you shouldn’t, either. Generally, banks want to see a 1.2 or higher ratio. That provides a little cushion to afford the payments in case things get worse.
Used: For buy and hold investors
Cash flow / cash in deal
- Yearly cash flow (NOI – debt service): $10,000
- Cash into deal: $40,000
$10,000 / $40,000 = .25 or 25% cash-on-cash
Cash-on-cash return is also simple to calculate and tells you what your return will be in the first year of holding the property. This is a great calculation for investors who are intent on holding a property. It also helps you decide whether to use leverage—and what kind of leverage—as you can easily calculate how your cash-on-cash return will change if you reduce your cash invested by adding debt, which also increases the accompanying debt service.
In the end, cash-on-cash is the most important number: It indicates whether or not financing a cash investment is a good idea. In other words, cash-on-cash return computes the rate of return on an investment property on the basis of the cash invested in it.
Let’s look at the above example. If you had $40,000 in the deal and made $10,000 that year, your cash-on-cash return is 25 percent. This is a critical calculation not only when it comes to valuing a property, but also when it comes to evaluating what kind of debt or equity structure to use when purchasing it.
The 50 Percent Rule
Used for: Estimating property expenses
Operating income x 0.5 = probable operating expenses
- Operating income: $100,000
Operating expenses = $100,000 * 0.5 = $50,000
This is a shorthand rule used to estimate property expenses. Whenever possible, use real numbers—i.e., the operating statement—but either way, this rule will help you filter out deals that don’t make sense. Just remember, a nicer building will have a lower ratio of expenses to income than a worse one. Plus, other factors, like who pays the utilities, comes into play. Don’t simply rely on this rule.
The 70 Percent Rule
Used for: Determining an offer price
Offer price = (0.7 x after repair value) – rehab
- After repair value: $150,000
- Rehab: $25,000
Offer price = (0.7 x $150,000) – $25,000 = $80,000
Personally, I think this rule beats the 50 percent rule. The 70 percent rule helps you decide on an appropriate offer price. (And remember: You should never just offer the asking price, or even the market value of the property, per se. You should offer what suits your investing methods.) Always crunch the numbers down to the closing costs before actually purchasing a property. Any offer based off the 70 percent rule should be just fine—as long as your rehab estimate and after repair value estimates are correct.
Used for: Understanding lifetime returns
Total cash distributions / total equity invested
- Total cash distributions: $273,000
- Total equity invested: $150,000
$273,000 / $150,000 = 1.82 equity multiple ratio
The equity multiple (EM) ratio helps understand total cash return over the life of an investment. This is also an income and equity metric.
The EM differs from the IRR in that it does not take into account the length of the investment period or the time value of money. Because it does not factor in discount to present value and does not take risks or other variables into account, EM should not be looked at in isolation. Paired with IRR, however, you have a powerful combination of metrics.
The EM is a static factor, meaning it will not deviate year to year based on income or expense fluctuations.
Using Calculations for Real Estate Investment Property Analysis
The most important thing to remember when running these calculations is simple: One number does not a decision make. Real estate investment analysis requires a whole suite of metrics and calculations—because every one of these numbers tells you something different. Solid positive cash flow alone doesn’t make a property worth buying.
Which calculations are essential for you?
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.