Investing in real estate requires many considerations, perhaps the most important being timing. But then there are the essentials, the basics you need to be aware of to properly analyze the risk-reward factor before you put down a single dollar of your own money. In this group are real estate calculations. Many are simple and usually are not forgotten by experienced real estate investors, but for new investors they can be easily overlooked. And even experienced investors can use a refresher course. With this in mind, here are real estate calculations every investor should memorize.
This is arrived at by dividing the Net Operating Income by the Total Price of the Property. The result will be a positive value such as 9.2% (0.092). Primarily used to valuate larger properties such as apartment complexes and commercial buildings, it can be applied to smaller real estate properties such as homes but only under special circumstances. Your result does not stand alone but is to be compared with similar properties in the area. The bigger the gap between your higher value Cap Rate and the surrounding area, the better it is for you.
Debt Service Ratio
If you are looking for a bank to provide some financial backing for your real estate investment, this is considered to be the most important number banks look at. It is calculated by dividing the Net Operating Income by the Annual Debt Service. The desired result will be a value above 1.00 because anything less means you will be losing money on your investment. As a general rule, a bank will be looking at a Debt Service Ratio of at least 1.20. But that is only part of the importance of the value. The result will be compared with your own Debt Service Ratio which would be that of your company or your portfolio.
Here you divide the Monthly Rent by the Total Price of the Property. The result will be a positive value such as 2.81% (0.0281). While Cap Rate is preferred for larger real estate investments, Rent/Cost is preferred for homes. Where you have to be careful is to compare apples to apples. Your result used in a high crime area will be meaningless in a high income area. One piece of data that is useful is the national Rent/Cost average, which is 0.7% (0.007).
The 50 Percent Rule
One of the most commonly known formulas, it is calculated by multiplying the Operating Income by 0.5 (or dividing it by 2). While it is easy to calculate and remember, some analysts advise not to put too much emphasis on the final result. There are other considerations such as who is paying for the utilities and the general physical condition of the property. It is useful, but not something to be taken in isolation of other factors.
The 70 Percent Rule
Use this number when you are in negotiations for an offer price. Take the After Repair Value of the property and multiply it by 0.70. Take that value and subtract it from any Rehab costs and the result will be what is called the Strike Price. The important factor here is that you accurate estimate your Rehab costs and After Repair Value, otherwise you run the risk of paying too much.
Cash on Cash
You can see this value as one that gives you a very good idea of what your return on investment will be. First you will calculate your Cash Flow by subtracting the Net Operating Income from the Debt Service. Take that number and divide it by the Cash In Deal to arrive at the Cash in Cash value. It will be a percentage, such as 0.28 or 28%. When you are deciding on the type of debt or equity structure to choose when buying a property, this value becomes critical.
In calculating Gross Yield you divide the Annual Rent by the Total Price of the Property. If this looks familiar, it’s because it is the annualized version of the Rent/Cost valuation. You are most likely to see this in the valuation of larger real estate portfolios.
These are the basics you should have available in your direct memory, ready for access at any time when considering any type of real estate investment. Depending on your specific investment goals, there are other calculations you want to have handy, but the lion’s share of those can be kept on a smartphone or calculator. But you’ll probably want to have these memorized just in case your smartphone battery is running low and you have a decision to make.