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All of these formulas are for educational purposes to share how basic real estate investment analysis is often conducted. They are for your personal use as you see fit. None of them are able to guarantee a particular return on your money because there are so many factors and variables that can affect your real return. For example, your property taxes could go up or down, your vacancy and maintenance could be higher or lower than the assumptions you used in your calculation, the next tenant you have might pay more or less than the first tenant as the rental market could change and market rents could go up or down, along with a number of other variables. So, nothing is ever guaranteed. Accordingly, you should never rely on someone else’s calculations but always do your own calculations as part of your due diligence based on numbers and assumptions with which you personally are comfortable. There are also many more complicated analytics that investors use to analyze and valuate investment property. For example, none of these formulas above take into account built-in equity, mortgage principle reduction, future appreciation projections, tax benefits, the time value of money, adjustments for inflation, etc. Always remember to consult with your own personal financial, legal and tax professionals before buying any real estate.
Understanding Real Estate Investment Analysis
Now the fun part: Analyzing properties to see how much cash flow they will put in your pocket!
Whether you are good at math or not, these are a few of the basic calculations commonly used for real estate investment analysis. There are many more advanced ones, but these are some of the simplest formulas that you can use to compare buying opportunities based on some of the core fundamentals.
Gross Rent Multiplier (GRM)
Perhaps the simplest form of real estate investment analysis is the Gross Rent Multiplier which just measures the price to rent ratio.
GRM = Purchase Price / Annual Gross Scheduled Rent
Let’s say you purchased a property for $125,000 and it rented for $1,300/month, which would be an annual gross scheduled rent of $15,600 (just multiply your monthly rent by 12 to get this). So, in this example:
GRM = 125,000 / 15,600
GRM = 8
Analytical Note: A GRM is like a golf score: the lower the better.
Net Operating Income (NOI)
While a price to rent ratio is simple and easy to calculate, it does not take into account your operating expenses. Some markets have much higher property taxes than others for example so to get a more accurate analysis of how much money will go into your pocket, you need to move on to more comprehensive calculations.
Your Net Operating Income (NOI) is your total gross scheduled rent minus all your expenses—property taxes, insurance, HOA fees if any, property management fees, "vacancy" and "maintenance" estimates.
NOI = Gross Scheduled Rent – Operating Expenses - Maintenance and Vacancy Estimates
Important Note on "Vacancy" and "Maintenance": Smart investors always make sure to factor in "vacancy" and "maintenance" estimates when analyzing properties, even new or fully renovated turn-key properties that have tenants in place at closing. This is because if you hold a property over the long term there will eventually be tenant turnover, vacancy and maintenance, all of which cost you money and affect your cash flow. Maybe your property will have no vacancy for 3 years, but then the tenant leaves and your property is vacant with no income for 60 days until a new tenant moves in. Or maybe you have no repairs for a couple years, but then you have an expensive one. Well, if you account for all that up front and amortize your estimated vacancy and maintenance across every month (we usually suggest estimating at least 5% of the monthly rent for maintenance and 7% of the monthly rent for vacancy), then you are not caught off guard when it occurs, because you factored it in from the beginning.
So let’s use our example above again with the $125,000 property with $1,300/mo rent and include some sample expenses:
|Gross Monthly Rent||:||$1,300|
|Net Operating Income||:||$804/mo|
Capitalization Rate (Cap Rate)
A Capitalization Rate (Usually called a "Cap Rate" for short) is simply your annual net operating income divided by your purchase price.
Cap Rate = Annual NOI / Purchase Price
So, sticking with our example above, you would multiply your $804 monthly NOI by 12 to get your annual NOI of $9,648.
So, in this example:
Cap Rate = $9,648 / $125,000
Cap Rate = 7.7%
Analytical Note: The higher the Cap Rate, the better
Important Note on Running Your Own Numbers: While a cap rate is one of the most common formulas used to for real estate investment analysis, ALWAYS be sure to check the calculation and make sure the person presenting it to you has calculated it properly. For example, MANY sellers quietly omit the maintenance and vacancy assumptions (which in the example above would change the Cap Rate from a 7.7% to 9.2%, which is a huge difference!). If you were to just compare "cap rates" without confirming how they have been calculated, you would be seriously mis-analyzing the properties. This is why it is crucial for you to understand how these formulas work so that you can apply them yourself when doing your own real estate investment analysis.
Now, even when calculated properly, a cap rate does not take into account any financing you may have used to leverage your purchase. So, the final formula we will discuss here goes one additional step.
If you got financing on the property that means that you put less money down out of your pocket and it also means that you have an additional monthly expenses for your mortgage payment (often called "debt service"). You need to be able to analyze the results of this "leverage" and assess how profitable it is for you. The cash-on- cash return formula calculates the return on the total cash invested (which is your down payment plus closing costs plus any other initial expenses) and takes into account the additional "debt service" expense you now have.
Cash on Cash Return = Total Cash Invested / (Annual NOI – Annual Debt Service)
So, in our example, let’s say instead of paying cash you purchased this property for 20% down and received an 80% loan at 5% interest with fixed principle and interest payments for 30 years, and let’s say you had a total of $4,000 in closing costs (including lender fees, title fees, etc). On our $125,000 property that means your down payment is $25,000 plus your $4,000 in closing costs so your total cash invested is $29,000. Then if you got an 80% mortgage for $100,000 at 5% interest fixed for 30 years, your P&I monthly payment would be $537/mo (use a mortgage calculator to determine this, or ask your lender), which you then just multiply by 12 to get annual debt service of $6,444. So, in our example:
Cash on Cash Return = $29,000 / ($9,648 - $6,444)
Cash on Cash Return = 11.1%