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Real estate investing is about making money. To accomplish that, some real estate math is involved to help you determine whether you'll make enough money on a deal to make it worthwhile. But don't worry: Real estate math for investors isn't that bad. Once you learn which formulas to use that suit the type of investing you're doing, you can quickly plug in the numbers and find your answer. Here are seven real estate formulas and how to do them.
1. The 1% rule
The 1% rule is a good place to start to get your feet wet in real estate math. This simple calculation is for a real estate investor who'll use the investment as rental property. A general rule of thumb is that you should get at least 1% of the purchase price of the property in monthly rent. So if you buy a property for $200,000, you should get $2,000 a month in rent. Here's the calculation: 200,000 x .01 = 2,000.
2. Cash flow
Cash flow is another easy calculation to ease you into real estate math problems. It gives you the big picture of how your expenses jibe with potential income. To figure your cash flow, determine your monthly income and expenses. Here are some items to include, but your income and expenses may vary.
- Mortgage payments
- Property tax
- Landlord insurance
- HOA dues or fees
- Vacancy rate
- Property management
So if your monthly income is $2,000 and your expenses are $1,500, your cash flow would be $500. Here's the calculation: 2,000 - 1,500 = 500.
3. Net operating income (NOI)
Net operating income is determined the same way as cash flow; only you don't consider mortgage payments. This calculation is to help determine the profitability of an investment and is a metric you'll use to determine capitalization (cap) rate. (See No. 4 below.) So if your monthly income is $2,000 and your expenses (not counting your mortgage) are $1,000, your NOI would be $1,000.
NOI is also calculated yearly, particularly when figuring cash-on-cash return (see No. 6 below). If your yearly income is $24,000 and your expenses are $12,000, your yearly NOI would be $12,000. Here are the calculations:
- 2,000 - 1,000 = 1,000 (monthly)
- 24,000 - 12,000 = 12,000 (yearly)
4. Capitalization rate
Capitalization rate, or cap rate, is often used in commercial real estate. It measures the rate of return you can expect to get on your investment. You determine it by dividing the property's net operating income by its current value, assuming you bought the property for cash. This is thought to give you a natural value of the property and helps investors compare deals. So if you buy a building for $500,000 and your NOI is $40,000, your cap rate would be 8%. Here's the calculation: 40,000/500,000 = .08.
5. Return on investment (ROI)
Return on investment (ROI) shows how much profit you'll make on an investment. You determine it by taking the profit you make and dividing it by the cost of the property. ROI differs depending on whether you bought the investment property using cash or if you leveraged your money by taking out a loan. So if you paid $200,000 cash for a rental property and earned $20,000 for the year (rental income minus expenses), you would calculate ROI by dividing $20,000 by $200,000 to get 10%. Here's the calculation: 20,000/200,000 = 0.1.
If you took out a mortgage, let's say your out-of-pocket expenses, including the down payment, closing costs, and repairs, cost you $50,000. You have a monthly mortgage payment of $1,000. Let's say considering all that, you have earned $8,000 for the year. You would calculate ROI by dividing $8,000 by $50,000 to get 16%. Here's the calculation: 8,000/50,000 = .16.
6. Cash-on-cash return
The cash-on-cash return also lets you see how profitable your investment is. In that way, it's similar to ROI. The difference is the cash-on-cash return metric measures how much cash a real estate investment will generate, while ROI measures how much wealth is built up by a property. You determine cash-on-cash return by taking your NOI (see No. 3 above) and dividing it by your total cash investment. So if your NOI is $12,000 and your total cash investment is $200,000, your cash-on-cash return would be 6%. Here's the calculation: 12,000/200,000 = .06.
If you took out a mortgage instead of paying in cash, let's say your out-of-pocket expenses cost you $50,000. Now you calculate your NOI plus the yearly mortgage you pay, which let's say is $8,000. Your NOI would now be $4,000 ($12,000 minus $8,000), and your cash-on-cash return would be 8%. Here's the calculation: 4,000/50,000 = .08.
7. Gross rent multiplier
You can use the gross rent multiplier to give you a quick way to rank different investments for comparison purposes before you invest. It compares the gross rent you could receive to the fair market value of a property. To determine the gross rent multiplier, divide the property's price by the gross rental income. So if the price of the property is $200,000 and your gross annual rent is $24,000, your gross rent multiplier would be 8.33, which means it would take you eight years and three months of rent payments to pay for the property. Note that this is a rough figure that does not include expenses. Here's the calculation: 200,000/24,000 = 8.33.
The Millionacres bottom line
These real estate math formulas are useful to let you, the real estate investor, know whether to invest in a property in the first place and to compare the different investments you already have. Once you get the hang of doing these formulas, you might even find them fun to do.
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