Top 10 Real Estate Investing Calculations
Top 10 Real Estate Investing Calculations
Over the years I’ve found that these Top 10 Real Estate Investing Calculations are tried and true tools to help assess a potential real estate investment property. Investors use them to compare properties when making a decisions about which property to purchase. Another advantage of these calculations is that most investors can gather the necessary data and make the calculations themselves, saving time and money before spending funds on other due diligence activities such as inspections or reports on a particular investment property.
In this article, I’ll describe each calculation and provide the simple, effective formula for each type of calculation, as well as an example of how to use the calculation and under what circumstances.
1. Gross Operating Income (GOI)
Formula:
Income Gross Rents Possible |
50 units @$1,000/month X 12 months $600,000 |
+ Other Income | 10,000 (Laundry income) |
= Potential Gross Operating Income |
$610,000 |
– Vacancy Amount | -$30,500 |
= Effective Gross Operating Income | $579,500 |
Gross income includes both rental income and all other income sources associated with an investment property such as parking fees, laundry and vending receipts, etc. A subset of the GOI is the Effective Gross Operating Income which equals potential gross income less the vacancy amount.
The Gross Operating Income is a useful estimate of what income you can expect from an investment property and it is needed in order to calculate the Effective Gross Operating Income. If you don’t have a sense of the vacancy amount/percentage for your investment property then use the Vacancy Rate from comparable properties in the neighbourhood in which the property is located. Canadian Mortgage and Housing Corporation is another source of information for obtaining vacancy information.
The Gross Operating Income is also required for the calculation for Net Operating Income.
2. Net Operating Income (NOI)
Formula:
Income Gross Rents Possible |
50 units @$1,000/month X 12 months $600,000 |
+ Other Income | $10,000 (Laundry Income) |
= Potential Gross Operating Income |
$610,000 |
– Vacancy Amount | -$30,500 |
= Effective Gross Operating Income | $579,500 |
– Operating Expenses | $240,000 (40% of Rental Rate) |
= Net Operating Income | $339,500 |
Net Operating Income is equal to a property’s yearly gross income less vacancy allowance, bad debt allowance and total operating expenses. Gross income includes both rental income and other income associated with the property such as parking fees, laundry and vending receipts, etc. Operating expenses are costs incurred during the operation and maintenance of a property. They include repairs and maintenance, insurance, management fees, utilities, supplies, property taxes, etc. The following are not operating expenses: principal and interest, capital expenditures, depreciation, income taxes, and amortization of loan points.
Net operating income (NOI) is a key calculation used in several other very important real estate ratios. NOI is used to determine Return on Investment. NOI is also an essential ingredient in the Capitalization Rate (Cap Rate) calculation that is used to estimate the value of income producing properties.
Let’s assume a market capitalization rate* of 10% for the type of property you are considering purchasing and you have a rough idea of the NOI for similar properties in the same market. If you are evaluating a similar income property that is currently for sale and all you have is the market cap rate and an estimated net operating income of $50,000, you would estimate the value of this property like this.
*A market Cap Rate is calculated by evaluating the financial data from current sales of similar income producing properties in a given market place.
Example | |||
Net Operating Income | $50,000 | ||
Estimated Market Value = | ——————————- | ———————- = | $500,000 |
Market Cap Rate | 0.1 |
Note: Never believe the vendor’s number for NOI or even the Gross Operating Income, unless you can verify all the input numbers with supporting receipts. Do your due diligence, it will save you money, headaches and prevent you from getting in to a bad deal!
3. Capitalization Rate (Cap Rate)
3 iterations of Cap Rate Formula to obtain different desired information:
Net Operating Income | |
Cap Rate = |
—————————- |
Market Value |
Net Operating Income | |
Estimated Market Value = |
——————————– |
Cap Rate |
Estimation of Net Operating Income | |
Net Operating Income = | Market Value X Capitalization Rate |
The Capitalization Rate or Cap Rate is a ratio used to estimate the value of income producing properties. Investors, lenders and appraisers use the Cap Rate to estimate the purchase price for different types of income producing properties. The Cap Rate is the property’s net operating income divided by the sales price or value of a property expressed as a percentage. It incorporates a property’s selling price, gross rents, non-rental income, vacancy amount and operating expenses such as repairs and maintenance, property taxes, advertising, insurance, and any utilities you pay for. It does not include mortgage payment, income taxes or depreciation. These items are important additional legitimate expenses. A market Cap Rate is determined by evaluating the financial data of similar properties, which have recently sold in a specific market.
In my experience, many investors use the term Cap Rate, but don’t always fully understand it. Originally, it was used more often for commercial real estate or apartment block valuations and calculations. However, many real estate investors now use Cap Rates in relation to individual residential properties, whether that property is a single family dwelling, townhouse, or condo. This use is fine as long as you correctly understand its shortcomings and utilize the Cap Rate info in conjunction with other investment calculations or tools.
The Cap Rate may be used, as demonstrated in Section 2 above, to estimate NOI, or to provide a point of comparison between properties, or to determine if a property will achieve the Cap Rate you require. In this Section we’re considering the Cap Rate and how it relates to estimated market value.
Examples:
Net Operating Income | $50,000 | ||
Cap Rate = | —————————- | —————————- = | 0.1 or 10% |
Market Value | $500,000 |
Net Operating Income | $50,000 | ||
Estimated Market Value = | —————————- | ———————- = | $500,000 |
Market Cap Rate | 0.1 |
Estimated Net Operating Income = | Market Value X Capitalization Rate = | $500,000 X 10% = | $50,000 |
How to interpret a Cap Rate?
Cap rates vary from market to market, neighbourhood to neighbourhood, and product type to product type i.e. commercial vs residential, apartment building vs. single family dwelling, condo vs. townhouse, etc. In order to gain a more meaningful understanding of a particular property’s Cap Rate, it is best used when comparing like property type or an average of like property types in the same market – preferably in the same neighbourhood, otherwise the Cap Rate obtained for a particular property can be somewhat meaningless or misleading.
3 key uses for Cap Rates:
1. If you know what the common Cap Rate for a particular neighbourhood and property type, and you know the price of the property (assuming the Cap Rate was used for pricing the property), you can estimate what the net operating income will be.
2. The Cap Rate of a property you are researching will tell you if it is too high or low for an area, by just comparing the Cap Rate of the property to the average Cap Rate for a similar property type in the area.
3. If you decide you need a certain Cap Rate for a particular property type in an area, then you can use the Cap Rate to decide on the price you will offer. Once again, you will need to know what the average Cap Rate is for that type of property in that area to make an offer that is within reason for the area.
What are some of the limitations of Cap Rates?
• Cap Rate calculations use very few input numbers, and therefore are only a financial snapshot of the property. Knowing what input numbers are involved will provide greater perspective. Small changes in the input numbers can significantly change the result you get.
• Cap Rates are static and therefore will not provide any insight to future values i.e. appreciation.
• Cap Rates don’t include mortgage payments and therefore do not provide the full picture.
• Unless you have the exact numbers for rental income, vacancy rates, R&M expenses etc., it is just a best guess situation.
How to best use Cap Rates?
As mentioned above, because a Cap Rate uses just a few input numbers to make its calculation, it should only be used as a financial thumbnail sketch for what I call a “go or no go decision” to proceed to the next level of investigation. Cap Rates can help you decide what property type to be investigating for potential investment of a particular area, depending on the particular average Cap Rate for the different types of real estate investments, such as commercial vs. apartment buildings, vs. single family dwellings vs. townhouse vs. condo, etc.
4. Rent to Cost Ratio (RCR)
Formula:
Example | |||
Monthly Rent | $1,200 | ||
Rent to Cost Ratio = | ————————- | ————- = | 0.8% |
Purchase Price | $150,000 |
The Rent to Cost Ratio is provides a rough estimate of a property’s expected cash flow after all expenses. Once again due to the low number of input figures, it should be used as a thumbnail view of a property’s actual/potential performance. Generally, a reasonable RCR should be about 0.7%+ but it is dependent on the market. For example, for a $100,000 property, you should be able to charge at least $700 monthly rent in order to achieve the 0.7% ratio.
In the lower mainland/Metro Vancouver area, at this time, the RCR is generally about 0.50+/-%, due in large part to high purchase prices, therefore this regional market is not a “cash flow” type of market. There are going to be variances to this general RCR due differing types and ages of properties, as well as operating expenses (an important input figure) which can vary greatly from property to property. Ideally, for an investor, the RCR should be about 1% in order for the investment property to be a positive cash flow situation after ALL expenses. Generally, the higher the percentage the better the return.
5. Debt to Coverage Ratio (DCR)
Formula:
Example | |||
Net Operating Income | $50,000 | ||
Debt Coverage Ratio = | —————————— | ————- = | 1.25 |
Debt Service | $40,000 |
Another important ratio that is used to evaluate income-producing properties is the Debt Coverage Ratio or DCR. It can also be referred to as the Debt Service Coverage Ratio (DSCR). The Net Operating Income (NOI) is a key ingredient in this important ratio. Net Operating Income or NOI is divided by Debt Service which is the total of all interest and principal paid in a given year. Many Canadian lenders include the following in the Debt Service part of the calculation: the full year of mortgage payments, loan payments, and property taxes, condominium/strata/Home Owners Association fees, and any other debt associated with the investment property.
Lenders and investors use the DCR to measure the ability of a property’s income to cover its operating expenses and mortgage payments. A debt coverage ratio of 1 is break even. Many financial institution lenders require a minimum DCR of 1.1 to 1.3 to be considered for a residential or commercial loan. From a bank’s perspective and an investor’s perspective, the larger the debt coverage ratio, the better it is.
6. Cash on Cash Return (CCR)
Formula:
Example | |||||
Before-Tax Cash Flow | $15,000 | ||||
Cash on Cash Return = | ——————————- | X 100 | ———— | X 100 = | 15% |
Cash Invested | $100,000 |
The following shows how before-tax cash flow is derived.
Gross Income: | $54,500 |
– Vacancy Amount: | $2,500 |
= Gross Operating Income: | $ 52,000 |
– Operating Expenses: | $17,000 |
= Net Operating Income: | $35,000 |
– Annual Debt Service: | $20,000 |
= Before-Tax Cash Flow: | $15,000 |
Cash on Cash Return is a percentage that measures the return on cash invested in an income producing property. It is calculated by dividing before-tax cash flow by the amount of cash invested and is expressed as a percentage. If before-tax cash flow for an investment property is equal to $15,000 and the cash invested in the property is $100,000, the CCR is 15%.
CCR is used to evaluate the profitability of income producing properties. It can be useful when comparing investment properties, but is just one of many analysis tools. It only considers before-tax cash flow and doesn’t take into account an investor’s individual income tax situation and it doesn’t consider the wealth building potential of a property via mortgage principal and appreciation. A property in one area of a city may have a better CCR then a property in another location, but it may not appreciate as fast because of its location. One location may be more desirable than the other.
The higher the CCR, the better with respect to an investment property.
7. Return on Investment (ROI)
Formula:
Example | |||
Net income | $35,000 | ||
Return on Investment = | —————————- | ————– = | 0.1 or 10% |
Total Down Payment | $350,000 |
Return on Investment (ROI) and Return on Equity (ROE) mean the same thing and are used and interchangeable. The ROI calculation includes all sources of income associated with investment property, less the vacancy amount (income NOT realized due to vacancy), less all operating expenses and mortgage payment interest divided by the amount invested. I call this the operating ROI.
Including the current or estimated market value appreciation for a property adds another level to the ROI calculation which can provide a more complete picture on ROI.
ROI could also be calculated as the combination of CCR plus mortgage principal reduction plus any verifiable appreciation. The appreciation component is sometimes a little more difficult to ascertain until the property is sold but a bona fide appraisal will work as a reasonable evaluation for that property in the current market conditions at the time of the appraisal. Whether you do or don’t use the appreciation component in calculating ROI, using the CCR and principal reduction will provide you with a reasonable result for the parts of the investment that you can control.
ROI is one of the most used and useful calculations, because it ultimately uses more inputs and thus presents you with the information as to what rate of return is expected for the funds you are committing. It allows you to discern between several investments or the validity of a particular investment. Usually the higher the return for the market, the higher the risk is. But an extremely low return can also have its risks.
Example: | Total Down payment: $350,000 |
Income Gross Rents Possible: |
$100,000 |
+ Other Income: | $3,000 |
= Potential Gross Income: | $103,000 |
– Vacancy Amount: | $2,000 |
= Effective Gross Income: | $101,000 |
– Operating Expenses: | $31,000 |
= Net Operating Income: | $70,000 |
– Finance Interest: | $35,000 |
= Net Income: | $35,000 |
Example without Appreciation | ||
$35,000 | ||
ROI = | ————– = | 0.1 or 10% |
$350,000 |
Example with 5% Appreciation: | Appreciation = $350,000 X 0.05 = | $17,500 |
$35,000 + $17,500 | ||
ROI = | —————————– = | 0.15 or 15% |
$350,000 |
8. Break Even Ratio (BER)
Formula:
Example | |||
Debt Servicing Cost + Operating Expenses | $91,000 | ||
Break Even Ratio = | —————————————————— | ————– = | 0.9 or 90% |
Gross Operating Income | $101,000 |
Lenders use this ratio as an analytical tool to determine risk. Too high a BER is not desirable as it indicates a higher risk in order to achieve the Break Even Point where Debt equals Income.
9. Price per Square Foot (PSF) and Rent per Square Foot (RSF)
Formulas:
Example | |||
Market Value | $300,000 | ||
Price per Square Foot = | —————————————————— | ————– = | $429/SF |
Property square footage | 700 |
Example | |||
Rental Rate | $1,000 | ||
Rent per Square Foot = | —————————————————— | ————– = | $1.43/SF |
Property square footage | 700 |
Price per Square Foot and Rent per Square Foot are two calculations that investors use quite often, as they are easy to calculate and are very helpful when comparing similar investment properties, in advance of offer negotiations. When you have comparable property or market PFS and/or RSF, then these measurements are useful to determine if a property is overpriced for the square footage in comparison to other similar properties, or if it is underperforming in its rental income compared to other similar properties.
These calculations can be used for individual houses, condos, townhomes, commercial properties, and office leasing. Typically, when investigating multi-family properties sometimes instead of, or in addition to using a PSF or RSF breakdown, a Price or Rent per Suite is used. Builders and developers also use these calculations to ascertain construction feasibility.
For instance, in Vancouver, new properties are often selling in excess of $1,000/SF, so construction cost need to be much less than that in order to make constructing the property profitable.
10. Internal Rate of Return (IRR)
IRR calculations are commonly used to evaluate the desirability of investments or projects. The higher a project’s IRR, the more desirable it is to undertake the project. Assuming all projects require the same amount of up-front investment, the project with the highest IRR would be considered the best and undertaken first.
It is important that you understand the time value of money theory behind calculating internal rate of return (IRR). The essence of IRR is that a given amount of money now is worth more now than that same amount of money sometime in the future.
The Internal Rate of Return or IRR calculation basically measures the average annual yield on an investment. For an income producing property, the IRR calculation uses the initial amount invested in the property, and a series of projected cash flows, which are usually after taxes, and a projected After-Tax Sales Proceeds amount in a given year.
Because this is a more complicated formula, it is best to use either an excel spreadsheet IRR formula to do the calculations or use an online calculator to help you get the correct number.
In closing:
By no means are these all the investment calculations to use but use these Top 10 Real Estate Calculations to help analyze each investment property you consider buying and you’ll be in good shape to assess the deal. Every seller wants to make their “numbers” look as good as possible, especially with respect to revenue and expenses. Utilizing these effective calculations enables you to check out the actual numbers, make your own assessment of the investment opportunity and determine what’s realistic for that particular market. These calculations together with your assessment of the type of property, its condition and location will enable you to determine if a particular property is the right one for your real estate investment portfolio.
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