Basics of Real Estate math as explained by AI

[Jimmy O'Connor]

Hey All!  

For those of you starting out, it seems like terms and equations for rental properties is like speaking another language, especially if you are not good at math. 
I typically type these guides up myself but wanted to see if the New Chat AI could produce.... spoiler alert, it can. 

Here are 5 basic equations to understand with examples as generated by the new Chat AI Robot:

1. Capitalization rate (Cap rate): The capitalization rate is used to determine the potential return on investment for a rental property. It is calculated by dividing the property's net operating income (NOI) by the purchase price (or current market value).
• Step 1: Determine the property's net operating income (NOI). This is calculated by subtracting the property's operating expenses (such as maintenance, repairs, insurance, property management fees, etc.) from the gross rental income.
• For example, if the property generates $24,000 in gross rental income per year and has operating expenses of $10,000 per year, the NOI would be $24,000 - $10,000 = $14,000.
• Step 2: Divide the NOI by the purchase price (or current market value) of the property. For example, if the property was purchased for $200,000, the cap rate would be calculated as follows: Cap rate = $14,000 / $200,000 = 7%.
  
2. Gross rental multiplier (GRM): The gross rental multiplier is a quick way to estimate the value of a rental property based on the income it generates. It is calculated by dividing the purchase price (or current market value) by the gross rental income.
• Step 1: Determine the gross rental income of the property. This is the total rent collected from tenants over a given period of time, before any expenses are deducted. For example, in this sample, the property generates $24,000 in gross rental income per year
• Step 2: Divide the purchase price (or current market value) of the property by the gross rental income. For example, if the property was purchased for $200,000, the GRM would be calculated as follows: GRM = $200,000 / $24,000 = 8.3.
  
3. Gross income multiplier (GIM): The gross income multiplier is similar to the gross rental multiplier, but it is based on the gross income of the property rather than the gross rental income. It is calculated by dividing the purchase price (or current market value) by the gross income of the property.
• Step 1: Determine the gross income of the property. This includes all income generated by the property, including rent, laundry income, parking income, etc. For this sample, the property generates $30,000 in gross income per year
• Step 2: Divide the purchase price (or current market value) of the property by the gross income. 
• For example, if the property was purchased for $300,000, the GIM would be calculated as follows: GIM = $300,000 / $30,000 = 10.
  
4. Cash on cash return: The cash on cash return is a measure of the annual return on investment for a rental property. It is calculated by dividing the annual cash flow (before taxes and depreciation) by the total cash invested in the property.
• Step 1: Determine the annual cash flow of the property. This is calculated by subtracting the annual operating expenses (including principal and interest payments on any mortgages) from the gross rental income.
• For example, if the property generates $24,000 in gross rental income per year and has operating expenses of $12,000 per year (including mortgage payments of $8,000), the annual cash flow would be $24,000 - $12,000 = $12,000.
• Step 2: Divide the annual cash flow by the total cash invested in the property. 
• For example, if the investor put down a 20% down payment ($60,000) on a $300,000 property, the cash on cash return would be calculated as follows: Cash on cash return = $12,000 / $60,000 = 20%.
  


5. Debt service coverage ratio (DSCR): The debt service coverage ratio is used to determine the ability of a rental property to generate enough income to cover its debt payments. It is calculated by dividing the net operating income (NOI) by the total debt service (principal and interest payments).
• Step 1: Determine the net operating income (NOI) of the property, as described in the example for the cap rate above.
• Step 2: Calculate the total debt service (principal and interest payments) on any mortgages for the property:
• For example, if the property has a mortgage with a principal of $200,000 and an interest rate of 4%, the total annual debt service would be $8,000 (4% of $200,000).
  

Step 3: Divide the net operating income (NOI) by the total debt service.

For example, using the numbers from the previous steps, the DSCR would be calculated as follows: DSCR = $14,000 / $8,000 = 1.75.

The debt service coverage ratio is generally expressed as a ratio or a percentage. In this example, the DSCR of 1.75 means that the property generates enough income to cover 1.75 times the amount of its debt payments. A DSCR of 1.0 or higher is generally considered to be sufficient to meet debt obligations, although some lenders may require a higher DSCR.

[Joe Villeneuve]

Only formulas that matter are the ones where the answer is in $$$$ and not in %%%%%.  Percentages tell you nothing of value, that is unless you spend percentages.  They don't tell you how much money you make.  They are simply a way of keeping score, but the scoreboard has nothing to do with the score %%%% are calculating.

The only formulas that matter, because they are the only ones where the answers are in dollars, are as follows:

1 - Cash Flow: Take rental income (plus any other cash only income) and subtract all expenses that are paid for by the landlord/REI ONLY. If the tenant pays for it directly, don't include it (i.e...utilities). If the Landlord/Owner pays for it out of the rental income, then include it (i.e...taxes, insurance).

2 - Cost Recovery: Divide the Down Payment (plus any other CASH ONLY costs that come out of the Landlord/REI pocket, i.e....repairs, vacancy costs, added payments towards the principle made by the REI, negative Cash flow) by the yearly Cash Flow. This tells you how quickly the REI should recover their cost.

3 - Starting Equity:  Subtract the debt principle (mortgage and any other debt directly associated with the purchase of the property) from the Property Value (this could be higher/lower than the purchase price).  Note the Down Payment is equity, that you paid for.

[Chris Seveney]

@Joe Villeneuve

Great answer, I remember once taking to an investor asking about returns and his reply was

“My wife doesn’t care what percentage we got, she wants to know how much cash we made”. Tell me what you think we will make in dollars I don’t care about percents.

#truestory

[Nathan Gesner]

I'm more concerned about this growing idea that artificial intelligence (AI) can answer questions for us. Why would you ask a computer to explain real estate math when there are already articles written by real investors that explain this? What did the AI produce that hasn't already been produced by real people with real experience?

I think computers are making a society that is lazy and dumb.

[Carlos Ptriawan]

Quote from @Nathan Gesner:

I think computers are making a society that is lazy and dumb.

In the good old days, I use to drive to any city in US --even internationally--, using actual maps to find a specific street. Kid nowadays needs iPhone to travel just two miles.

We are dumb.

That's the time when BnB is actually "Bed And Breakfast", we use the actual taxi to reach somewhere in the city, rather than push a button from phone.

[Bruce Woodruff]

I would question any information provided by anything not a human being with decades of experience and skin in the game. Just my .02....

And @Nathan Gesner is absolutely right about computers making us dumb. Just look at all the posts by young people asking about the best Apps to run STRs, best YT videos for RE investing, etc. It's scary at best. C'mon people, do your own research. Can't believe people will entrust their spending hundreds of thousands of dollars on a computer algorithm .......

[Joe Villeneuve]

I don't know. I think computers are a great thing, when used in moderation. Their ability to do complex math, akureretlie spill chick our wurds and centanses, and think for us. Let's face it, the world is changing. We have things like WARt in baseball that can predict what a player will do based on what they have done in the past. Imagine if we had that for REI. There would be no profits, because there would be no change in property values, since all future PV would be based on past PV.

Computers also work around the clock, they have no neg effect from time zones, and they never seem to get tired.  And the best part is, th  e y nevvver, (I'll have to finish this later, my battery issss going de......

[Drew Sygit]

I don't need to know how a microwave works as it has no negative affect (or positive) on my income.

Trusting a computer to make investments? hmmm...

[Mike Dymski]

Pretty good.  It's the next progression of a google search, although will have to work out the kinks of misinformation (which is all over the internet anyway).