Are you a real estate investor looking for ways to maximize your return on investment? If so, then understanding the basics of investment property calculations is an essential skill.
With the right calculations, you can make smart decisions about which properties to purchase and how to maximize your profits. In this blog post, we’ll explore the four most important calculations for real estate investors: cash flow, loan-to-value ratio, cap rate, and internal rate of return. Read on to learn more about these key metrics and how they can help you maximize your ROI.
1) The Cap Rate Calculation
When evaluating rental property investments, one of the key rental property formulas to be aware of is the Capitalization Rate or “cap rate”. This investment property rule helps real estate investors determine the potential return on their investment by calculating a ratio between the property’s net operating income and its current market value.
The cap rate will help real estate investors assess the risks associated with an investment and provide them with an idea of what kind of return they should expect from it.
To calculate the cap rate, divide the property’s net operating income by its current market value. This calculation helps real estate investors compare investment properties of different sizes and in different locations, since it allows them to make apples-to-apples comparisons.
A higher cap rate typically indicates a higher potential return on the investment, while a lower cap rate may indicate a lower risk. It’s important to note that cap rates do not take into account certain factors, such as cash flow, capital appreciation, tax benefits, or financing costs.
This means investors should consider other rental property formulas and investment property rules when making their decisions.
Who determines the current market value?
A real estate appraiser can conduct an inspection and evaluate like-kind properties to accurately estimate a property’s current market value for investment purposes. However, appraisals are expensive and can be time-consuming.
As an alternative, real estate investors can use various investment property valuation rules like the “sales comparison approach” for single family rentals or “income capitalization approach” or “gross rent multiplier” approaches for multifamily and commercial real estate to estimate a property’s current market value.
Are cap rates determined by the neighborhood?
The location of an investment property affects both the current market value and net operating income, which ultimately affects the cap rate. Therefore, cap rates can differ depending on the area where the property is located.
Properties located in popular neighborhoods tend to have higher cap rates due to increased demand for rentals which drives up prices and increases overall returns. On the other hand, neighborhoods with low demand usually have lower cap rates due to less competition for rentals and therefore lower rents.
Additionally, investors need to consider local economic conditions such as job growth and infrastructure development as these factors will also impact the local housing market and could affect the cap rate of a particular investment property.
2) The Cash-on-Cash Return Calculation
The Cash-on-Cash Return is one of the most important rental property formulas to consider when evaluating an investment property. It is a simple calculation used to determine the return on an investment based on cash invested into it. It measures the pre-tax cash flow produced by the property in relation to the amount of cash initially invested.
Calculating the Cash-on-Cash Return:
The cash-on-cash return can be calculated by dividing the annual pre-tax cash flow of a property by the total amount of cash initially invested in the property. This ratio will tell you how much money you are earning on your cash invested.
For example, if you invested $400,000 in a rental property and it produces an annual pre-tax cash flow of $40,000, then the cash-on-cash return would be 10%. ($40,000/$400,000 = 0.10 or 10%).
In other words, for every $1 of cash you have invested, you are earning $0.10 in return. This metric is useful when evaluating multiple investment properties as it allows you to compare your return on cash invested.
As an investor, you should strive for higher returns as this means more money earned from your investment. When evaluating an investment property, make sure to use the cash-on-cash return as one of the rules for assessing whether the property is worth investing in or not.
3) The Debt Service Coverage Ratio Calculation
The Debt Service Coverage Ratio (DSCR) is an important investment property rule that real estate investors use to determine if a potential property is a good investment. The ratio compares the amount of income generated by a property to the total cost of servicing its debt.
This calculation helps investors evaluate whether they can cover the cost of the loan payments, as well as any other expenses associated with the property.
To calculate the DSCR, divide the net operating income of the property by its total debt service. The debt service is the total of the monthly mortgage payment, property taxes, and property insurance.
For example, if the net operating income of a home is $3,000 per month and the total debt service on the property is $2,400 per month, then the DSCR would be 1.25 ($3,000/$2,400). This means that there would be an 12.5% cushion to cover any additional expenses.
For a multifamily property, the DSCR would be calculated in a similar fashion. For example, if the net operating income for an 8-unit property is $7,600 per month and the total debt service is $6,800 per month, then the DSCR would be 1.11 ($7,600/$6,800). Again, this indicates that there would be an 11% cushion for additional expenses.
Knowing the DSCR for a potential investment property is critical for evaluating its profitability. A higher DSCR indicates that there is a greater margin of safety when it comes to covering the debt service and other expenses associated with owning the property. By understanding how to calculate the DSCR, investors can make more informed decisions when considering potential investments.
4) The Gross Rent Multiplier Calculation
The Gross Rent Multiplier (GRM) is a popular calculation used by real estate investors to help assess the potential returns of an investment property. It measures the relationship between the sale price and the annual rental income of a property and can be used to compare different properties and make informed decisions.
To calculate the Gross Rent Multiplier, first determine the Annual Gross Rental Income of the property you are considering investing in. This should include all regular rental income from tenants, and any additional income sources such as parking or laundry fees.
Once you have determined this amount, divide it by the sale price of the property. This will give you the Gross Rent Multiplier for that particular property.
For example, if a property has an annual gross rental income of $36,000 and a sale price of $400,000, the Gross Rent Multiplier would be 12 ($36,000 / $400,000 = 0.09).
The GRM can provide real estate investors with insight into potential returns on a particular property. Generally, a higher GRM indicates higher potential returns. However, it is important to remember that this is not an exact science and other factors should be taken into consideration before investing in a property.