5 Formulas Real Estate Investors Should Know

Investing in real estate requires you know and understand several calculations. Don’t let this fact intimidate you, however, as most of these formulas are easy to commit to memory. The more you understand about how the financial side of real estate is calculated, the better off you will be in the long run. The following is the top five real estate calculations every investor needs to know.

Capitalization Rate (Cap Rate)

Capitalization rate, or cap rate, is a calculation used to figure out what a property is worth or how well a property already owned is doing. A cap rate calculation has several advantages. It takes into consideration credit losses, vacancy, other incomes, and operating costs. It also does not require any multi-period estimates of cash flow. On the other hand, disadvantages of using cap rate include the fact that it only looks at the first year of operation, and it doesn’t take into consideration any debt financing.

Below is an example of a cap rate calculation. Cap rate is figured by dividing the Net Operating Income by the Total Price of the Property.

NOI = $25,000

Total Price = $300,000

$25,000/$300,000 = .083

Cap Rate = 8.3

Any cap rate over 8 is good, but ideally, you want to shoot for a cap rate that’s as good as, or better than, other similar properties in the area.

Cash on Cash Return

Ultimately, this is the most important calculation because it tells you what your return on your investment is. The cash on cash return is figured by dividing the cash flow by the amount of money put into a deal

For example:

Cash flow = $10,000

Cash put into the deal = $40,000

$10,000/$40,000 = .25

Cash on cash return = 25%

In the above example, $40,000 was put into the investment, and $10,000 was made during that year. The end result was a return on investment of 25 percent.

Gross Yield

Gross yield is a great formula that gives an indication of the value of a property in relation to market trends. Having said that, it should only be used when comparing the rental value of similar properties. This measurement is simply an estimate of expected cash flow since it does not take into consideration things like taxes, operating expenses, and debt financing. Gross yield is calculated by dividing the annual rent of a property by the total price of the property.

Annual rent = $9,000

Total property price = $100,000

$9,000/$100,000 = .09

Gross Yield = 9%

Debt Service Ratio

When it comes to obtaining financing for a property, this value is probably the most important where banks are concerned. This calculation lets a bank know whether you will lose money or not. The formula is calculated by dividing Net Operating Income by Debt Service. 

See the example below.

Net operating income = $25,000

Annual debt service = $20,000

$25,000/$20,000 = 1.25

Debt Service Ratio = 1.25

Typically, anything under 1 tells a bank that you will lose money each month. Getting financing with anything below this number is difficult. Ideally, banks like to see a debt service ratio of 1.2 or higher so they know you have a cushion to make the payments should something go bad.

Operating Expense Ratio

The operating expense ratio shows how much of your income is used up by operating expenses. Looking at this value over a several-year time frame can reveal important trends. This calculation is figured by dividing the Total Operating Expenses by the Effective Gross Income.

You can get a quick estimate of the operating expenses of a property you want to purchase by using the 50 Percent Rule. This simple formula, figured by multiplying the Operating Income by 0.5, helps you rule out deals that just don’t make sense. It’s best to use actual numbers from the operating statement (if available) when figuring this value.

Operating income = $100,000

$100,000 * 0.5 = $50,000

Estimated Operating Expenses = $50,000

Remember, nicer properties will have lower operating costs than properties that need work or are located in bad areas. Factors such as who pays the utilities and delinquencies and vacancies also make a difference. This rule is simply a guide and should not be relied upon for actual numbers.