When planning to buy a real estate property, the most important thing to get right is the real estate math associated with your purchase. This is because real estate is, well, expensive! And a difference of 1% in the value of a $1M property is a considerable amount of money.
To learn the 10 must-know real estate investment formulas, watch our video below:
So, in this real estate math post, I plan to guide you through the most important real estate formulas that you will need to use in order to increase your chances of having a successful investment and earn a good profit from it.
Return on Investment (ROI)
When talking about investing in real estate, it’s only natural to assume that the end goal of your investment is to earn a profit.
And, if you’re here, then chances are you’ve also heard the term: return on investment.
Of course, return on investment refers to the value that you’re getting back from investing your money in anything. But, how can you calculate that value?
There isn’t really a simple answer to that!
Return on investment is such a general word that represents the concept of earning on an investment. However, when talking about real estate investing in particular, there are a number of metrics that are commonly used, and that you will be using if you’re planning on investing.
So, let’s go over the most important real estate math that you will need to carry with you on your next investment journey:
Before Getting Started
The real estate math we’re about to go over will always have a couple of values that are included in most formulas.
These values are basically your base structure around which you build your real estate math: your income and your expenses.
Gross Operating Income
The income of a real estate property is the monthly or yearly cash that it generates.
This, of course, depends highly on the type of property you’re buying and what you want to do with it. When it comes to rental properties, their income will mostly consist of their rent. However, property owners might sometimes opt-in for finding more ways to generate money from their properties.
For example, as a property owner, you might want to rent out the sidewalk of your property as a parking lot if you don’t personally have a car to park there. Or, you might want to rent out your garage as a storage area for instance!
Regardless of the method that you want to use, the combination of these sources of income from your property is referred to as your gross operating income.
So, how do you calculate your Gross Operating Income for a rental property? It’s simple:
Gross Operating Income = (Annual Rental Income X Vacancy Rate) + All Other Income
In case you don’t know what vacancy rate is – it is the percentage of time during the year when the property is vacant / not being rented out. You can learn more about it here!
It is important to note that one source of indirect income or profit that people often neglect is the appreciation rate. A real estate property’s appreciation should not be taken for granted, as it is one of the most attractive aspects of owning a real estate property in the first place.
For that reason, when doing long-term real estate math, it is incredibly helpful to include the appreciation rate of the property as it might show you great opportunities that you would’ve otherwise missed.
On the other hand, there are several costs associated with owning a real estate property, from the costs of finding and purchasing the property, to financing costs, to maintenance costs.
All of these count as the expenses of the property.
Whether these expenses come as a one-time payment or a reoccurring expense, all of them should be included in your calculations in one way or another.
These are the main types of expenses that you should be on the lookout for:
- One-time expenses:
- Down payment
- Renovation costs
- Closing fees
- Agent fees
- Reoccurring expenses:
- Maintenance costs
- Loan payments
- HOA fees
Of course, the list goes on, but the essence is what matters here – it is extremely important to include as many expenses as you can think of in your real estate math calculations, as they can significantly affect the value of your investment in the long term.
Real Estate Math – The Formulas
Now that you know what your expenses and your gross operating income are, it’s time to get into the actual formulas that will tell you whether the property you want to buy is worth the money investment or not:
Net Operating Income
While the gross operating income is the combined income that your entire property generates; the net operating income, also referred to as cash flow, is the percentage of that amount that remains after paying all expenses.
So, the net operating income is basically your gross operating income minus all reoccurring or operating expenses.
The property’s cash flow, or NOI, can either be positive or negative. A negative cash flow means that your operating expenses are higher than your gross operating income, and therefore your property is costing you more money than it is generating.
Of course, as a rule of thumb in investing, you generally want to have a positive cash flow property in order to have a successful investment.
So, to recap, this is the simple formula for calculating Net Operating Income:
Net Operating Income = Gross Operating Income – Operating Expenses
Cash on Cash Return
One of the most crucial and commonly used formulas for real estate investors – the CoC allows investors to see how much value they would be getting from their property compared to the amount of cash that they invested in it.
The Cash on Cash Return is an especially important metric to track when you want to borrow money from a lender to buy the property. This is because the CoC doesn’t take into account the amount of borrowed money in its calculation.
Instead, the CoC only looks at the actual cash that you’ve invested. So, if you’re buying a property that costs $200,000, but you’re only paying $40,000 in cash and the rest in borrowed money, then you will only use the $40,000 for calculating your CoC.
Here is the formula for calculating the Cash on Cash Return:
Cash on Cash Return = Net Operating Income / Total Cash Investment
Please note here that the total cash investment doesn’t stop at the down payment you made on the property, but it should also include all one-time expenses that incur on purchasing the property, such as closing fees and renovation costs.
The Cap Rate is another formula that is widely used by real estate investors, and it allows you to calculate the investment opportunity of your property based on its market value.
This means that the Cap Rate doesn’t take into account your method of purchasing or financing the property or the one-time costs that incur when buying it.
Instead, the capitalization rate will show you what the property looks like in terms of investment in the overall market, making it easy to compare it with other properties that are similar to it.
When looking at a big list of properties for sale and you can’t decide where to start, the cap rate is usually a good metric to use as it will greatly help you narrow down your options to properties that have an intrinsic value of investing.
Here is the formula for calculating the capitalization rate of a real estate property:
Cap Rate = Net Operating Income / Market Value of the Property
Real Estate Math – Other Formulas
Now that you know the most important formulas to use when assessing your potential purchase or real estate investment, there are plenty of useful real estate math formulas out there that can also help you when planning your investment.
Here are a few:
The break-even ratio is a formula that is used to see the occupancy rate that you will need on a rental property in order for it to break even and cover its expenses.
Break-Even Ratio = Total Expenses / Gross Operating Income
This might be a bit confusing to some, so let me explain it.
If you have a property that has total expenses of $30,000, and a gross operating income of $35,000, then its break-even ratio would be (30,000 / 35,000 = 85%).
What this means is that you will need an occupancy rate of 85% or higher in order for your property’s rental income to break even.
So, as a general rule, the higher the break-even ratio is, the harder it will be for the property to cover its own expenses.
Gross Rent Multiplier
The Gross Rent Multiplier (GRM) is a metric that’s used to calculate the ratio of the price of a real estate property to its annual rental income before accounting for expenses.
The value of GRM, in this sense, refers to the number of years that it would take for the property to pay for itself before accounting for its expenses.
Here is the formula for calculating the Gross Rent Multiplier:
Gross Rent Multiplier = Property Price / Gross Rental Income
Real Estate Math – Want to Make It Simpler?
As you can see, the real estate math that you need in order to estimate the value of a property and determine the future of your investment really isn’t that hard!
In fact, the biggest hurdle that stands in the way of most real estate investors isn’t knowing the real estate math, but knowing how to use that math to help them make smart and calculated decisions.
This is because while calculating these formulas for a single property can be easy, doing it for a large number of properties and being able to compare them to determine the best investment opportunity is an entirely different matter!
So, What Should You Do?
In the past, whenever a real estate investor wanted to make an investment, they would need to first gain access to large amounts of data and listings that would enable them to run the real estate math.
Once they’ve gathered all the data they need, they would then have to enter this data into large excel sheets or even use pen and paper and go through a long tedious process of comparing listings and identifying the good apples from the bad ones.
Nowadays, however, we live in an age of technology where for every need you have, there is a tool to help you do it.
Similarly, when it comes to investing in real estate and doing real estate math, there are plenty of tools and calculators out there that can help you.
But if you’re looking for a tool that was designed specifically for real estate investors like yourself, and which offers options that can cover all of your real estate investing needs, then look no further than Mashvisor.
Mashvisor is a real estate platform that was designed for real estate investors to help them find properties and analyze them with ease using a wide selection of analysis tools and calculators that are easy to use and that will help you calculate all the real estate math that you need.
Make informed smart decisions based on actual data which has been broken down to you in an easy-to-read and understand manner, complete with all the metrics that were mentioned in this article, to help you make a profit on your investment.
Real estate math really isn’t that hard to understand. With a bit of practice, and after comparing a few properties on your own, you will get the hang of it, and these formulas will be imprinted in your brain for the rest of your investment career.
Don’t forget to check out Mashvisor and subscribe to gain access to tools that will make you a professional-grade investor in no time!