7. The (Simple) Math of Real Estate
We break down the calculations most often used in evaluating our rental properties. Don't worry, this isn't College Calculus 404. It's all very simple! If you passed third-grade math and can use the calculator function on your phone you're all set.
Put what you’ve learned here into action. Download my free spreadheet which includes most of these calculations
When learning how to acquire and operate your first rental property, the terms thrown around to evaluate a rental property can get jumbled up in your head with the alphabet soup of all the financial acronyms. Let’s take a look at what you need to know to perform these calculations, and what each calculation tells us. Luckily, if you remember anything from your third grade math class and own a calculator, you can perform these calculations easily.
Let’s talk Residential property calculations:
Cash flow- Possibly one of the most important of them all! Your Cash in from rents, bank account interest minus Cash out (operating expenses, debt payments, capital expenditures) over a selected period of time equals your cash flow expressed in a dollar amount. Usually you’ll want to know what your cash flow is for an entire year. If you own a checking account you understand this concept already. Ideally, this is what you get to put in your pocket each month, quarter, or year. If you want to retire using real estate then this is how you do it! However, If you consistently have negative cash flow then you’re coming out of your own pocket for unexpected expenses or even the mortgage. Ouch!
Rent-to-value: Here’s one that you don’t even need a calculator for. This is mostly a rule of thumb to help you quickly evaluate if a property has a chance of cash flowing or not. If you’ve heard of the 1% rule then this is it. If we want to buy a property for its cashflow, then we want the total possible rent you can collect each month to be at least 1% of the purchase price. Ideally, more. A Quick example- a 400,000 dollar property needs to bring in at least 4,000 dollars a month in rent. Again, 1% is just a rule of thumb. Ideally, you’ll want closer to 1.5%.
Return on Investment or return on Equity -aka ROI. There’s a few ways to go about this one. If you own your property with a mortgage, then we’ll want to add the principal portion of your mortgage for the entire year to your cashflow for the year. Then divide by the total amount of cash you’ve invested. However, let’s say you flip houses. You’ll want to know your ROI when you sell. So we’ll take our forecasted sale price, minus the purchase price and rehab expenses divided by our cash invested. ROI is expressed as a percentage.
Now, onto Commercial properties:
-Everything we talked about in residential applies. Plus the following:
-Net Operating Income, or NOI. This is one of the most important numbers for your property. It’s value will increase and decrease by this number. If you’ve heard the expression about something improving the bottom line, they’re talking about NOI. We calculate our NOI, usually in one year increments, by taking our total income collected, and subtracting all our operating expenses. Notice the mortgage and income taxes are excluded. The NOI purely gives us an idea of what the property itself can do. After all, not all mortgages are the same and everyone pays a different amount for income tax.
-Capitalization rate or plainly, cap rate. This number combined with our NOI will give us the value of our commercial real estate. Remember, residential real estate is valued by its comparables and cap rate doesn’t apply to the residential realm. The cap rate is determined by the market as a whole and we express it as a percentage. A really fancy class A property might trade at a high 2 cap and a war zone property in gang territory might trade at a low 15 cap. To calculate our cap rate, we take our Net Operating Income and divide by the properties current market value. Easy right? But what if we made improvements to our property, the NOI has gone up and we want to figure out what our property is now worth? Just take your NOI and divide by the cap rate percentage. For example, 25,000 in NOI divided by point zero eight for an eight percent cap rate. That gives us an increase in property value by 312,500.
-Cash on Cash- The ratio between the yearly cashflow, which we already mentioned, and your capital invested invested expressed as a percentage. It’s purely a performance indicator of the cash you used to buy the property and how well it puts money in your pocket. There isn’t one specific number I can tell you to look for here. Consider some variables: If you buy a property in all cash, your cash on cash return will be MUCH lower than if you buy with 25% down and a mortgage. Also, let’s say you buy with no money down. Then your cash on cash would be infinite. If you bought a very nice property and are mostly going for an appreciation play, your cash on cash would be lower than if you bought, say, a class C apartment complex in the midwest and are going for cashflow.
-Internal Rate of Return or IRR. This is probably the most sophisticated calculation of all the ones we’ve discussed. The IRR allows us to forecast our cashflows and future sales price then condense it all down into one number expressed as a percentage. Let’s say you buy an apartment complex, plan to make improvements and increase the rents as you do so. You fully expect to increase your cash flows every year as you renovate and also realize a much higher sales price in the future since you’ve improved the property. This calculation is how we turn all of that into one number. If you want to calculate this, use excel or a fancy property analyzer. If you’re getting 15% or above, you’re doing well.
-Debt Service Coverage Ratio- If you’re just getting into commercial properties you’ll want to understand this concept of commercial loans. Since the bank in a commercial loan is primarily looking at the properties ability to produce income to repay the loan, the bank wants to know there’s some cushion in the cashflow after you pay your mortgage. The bank wants to see that if there’s an unexpected expense that pops up then you’ll still be able to pay. Typically, a 20 to 25 percent cushion above the mortgage payment each month is what they want to see as a minimum. If you’re crunching the numbers on your property and come up with a DSCR of less than 1.25, the bank will probably require a higher down payment to make the 1.25 minimum.