Don’t take a hunch – Crunch!
For today’s article, I’d like to share with everyone my top 10 general calculations to perform before investing in any real estate:
Loan to Value (LTV):
Unless you have enough money to pay off the entire property, you should consider getting a loan for your real estate investment. Therefore, one of the most critical ratios to consider is the LTV because it will affect the total amount you will pay to borrow the funds. In general, high LTV values are classified as “high risk” and borrowers would typically be charged more or required to purchase mortgage insurance, increasing their overall operating expenses.
Formula: Loan Amount x 100 / Market Value = LTV
Net Operating Income (NOI):
Any successful real estate investor would tell you the importance of calculating the NOI. It not only takes into account the annual gross income of properties minus vacancies, but also bad debt and total operating expenses. For those who don’t know, gross income includes any income associated with the property (eg, rent, parking, laundry); Operating expenses refer to all costs incurred during the operation and maintenance of the property (for example, repairs, insurance, utilities, property taxes, administration, etc.).
Formula: Gross Income – Vacancy, Debt, Total Operating Expenses = NOT ME
Capitalization Rate (CR):
To determine the value of income-producing properties, many investors calculate the CR as a proxy for estimating the purchase price of different types of income-producing properties. In general, the higher the sales price, the lower the capitalization rate, and the lower the sales price, the higher the capitalization rate.
As an investor, you want your capitalization rate (%) to be as high as possible.
Formula: Net Operating Income / Sales Price (Value) = CR
Gross Income Multiplier (GRM):
One of the easiest ways to determine a rough estimate of a property’s value is with the use of the GRM, which only requires two pieces of information: the sales price and the total possible gross rental amount. You can calculate the GRM monthly or annually, and it will give you a good indicator of how much cash flow the property is capable of producing.
Formula: Purchase Price / Annual Gross Rent = GRM
Debt coverage ratio (RCD):
The DCR is another vital ratio used to measure a property’s ability to pay its mortgage and other operating expenses. From an investor’s perspective, the higher the DCR value, the better, and a DCR ratio of 1 equals “breakeven.” Typically, many lenders and banks require a DCR of 1.1 to 1.3 before approving loans.
Formula: NOI / Debt Service (Total Principal and Annual Interest) = DRC
Balance Ratio (BER):
The BER is used to calculate the relationship between a property’s cash outflow and rental income to determine what percentage is spent compared to income. Typically, many lenders and investors look for a BER of <85%. The reason is that they want some form of insurance in case rents drop ~15% before the property breaks even.
Formula: Debt Service + Annual Operating Expenses / Gross Operating Income = BER
Return on Investment (ROI):
To be a successful investor, you must determine your ROI to ensure that you receive a return on your investment(s) after deducting all associated costs and expenses. ROI would not only help assess the profitability of an investment, but also its efficiency and effectiveness relative to other properties or investments.
Formula: Investment gain – Investment cost / Investment cost = KING
Cash vs. Cash Return (CCR):
CCR is a percentage that measures the return on cash invested in a rental property.
Formula: Cash flow before taxes / Cash invested x 100 = RCC
Rating (A):
Of course, not all real estate investments will be short-term investments. There are some properties that you will want to hold onto for the long term in an effort to take advantage of the appreciation because you believe that these properties will be worth much more in the future. Instead of getting instant gratification through a quick sale, you could keep the property and gradually make improvements in an effort to raise the rent. Remember, many investors would be happy to pay more for a property with high ROI and appreciation.
Formula: Future Resale Price – Original Sale Price = HAS
Depreciation (D):
Depreciation is another important consideration when investing in real estate. To calculate basic depreciation, investors need to know the initial cost of the asset and its residual value, including the estimated “useful life.”
Formula: Cost – Salvage Value / Estimated Useful Life = D.
To illustrate, let’s say an investor bought a property for $100,000 and its useful life was determined to be 10 years, then the property depreciates by $10,000 annually.
Henry Ford once said that “the best we can do is assess the possibilities, calculate the risks involved, estimate our ability to meet them, and then make our plans with confidence.” By using the 10 calculations mentioned above, he is able to crunch the numbers to take the guesswork out of any real estate investment and approach every deal with confidence.