Real estate investors use a variety of mathematical tools to analyze the performance of their properties, both before and after purchase.Understanding the tools begins with knowing the terms involved and what they mean to your bottom line.
Key Takeaways
- Some of the most important figures you need to know when evaluating a rental investment include gross operating income, net operating income, capitalization rate, and cash flow figures.
- Lenders are interested in your debt service coverage ratio (DSCR) and breakeven ratio.
- Understanding these numbers can help you determine whether an investment will be a fantastic money-maker or a cash-draining disaster.
Potential Gross Income (PGI)
Potential gross incomeis revenue a property is expected to producewithout making deductions for expected vacancy or credit loss. It's also known as gross scheduled income. It's a target number; actual rent is often lower.
The potential gross income calculation isfairly simple. Just multiply 12 months by the total rent expected per month.If the property is a multiple-unit building in which the units have different rents, you'll need to add up all the rents.
Gross Operating Income (GOI)
The gross operating income calculation is PGI minus losses due to vacancy and non-payment.
Costs when units are vacant include advertising for new tenants, doing minor maintenance, repainting and rehab, and management costs for a new lease.A general rule of thumb for an established property is to estimate vacancy expenses at 5% to 10% of gross rental income.
Gross Rental Multiplier (GRM)
It's not the most precise of tools, but the gross rental multiplier (GRM) can give you a quick comparison tool to decide whether you want to do a more thorough analysis of a property.
If you're shopping for a multi-family property, you might find that there are many for sale in the area. The GRM calculation gives you a fast tool to see which ones to bring to the top of your list for further research.
If the GRM is very high compared to other rentals in the area, it could mean the property is overpriced. A lower GRM means it'll take less time to pay off your rental property.
You can get the GRM for recently sold real estate by dividing the market value of the property by the annual gross income:
Market Value / Annual Gross Income = Gross Rent Multiplier
For example, if a single-family home property sold for $400,000, and the annual gross rent income on it was $24,000 ($2,000 per month) the GRM would be:
$400,000 / $24,000 = 16.7
Net Operating Income (NOI)
Net operating income is gross income minus the total of all operating expenses, such as management, repairs, and janitorial costs, to calculate. Keep in mind that these are only operating expenses, not mortgage payments, capital expenses, or depreciation.
The list can be long nonetheless. It typically includes the costs of management, advertising, janitorial, maintenance, repairs, legal, and accounting. A good rule of thumb for repair costs is about 5%, but this assumes the property is pretty much in prime condition—no glaring, expensive problems. Otherwise, anticipate up to 20% or even more.
Capitalization Rate
Thecapitalization rate is determined by usingoperating incomeand recent sold prices for other properties, then applying theseto the property in question to determine current value based on income. It's a tool used by almost all commercial and apartment investors, as well as lenders and others who want to calculate the value of a property based on its income flow and to compare it with other properties in the same market area.
You can find it by dividing net operating income by total property price. If NOI is $30,000 and price is $300,000, the equation would look like this: $30,000 / $300,000 = 0.1 for a cap rate of 10%. That's prettygood. Many investors look for a cap rate of 5% to 10%.
Cash Flow Before Taxes (CFBT)
Now take net operating income and subtract capital expenditures as well asdebt service (mortgage).
This gets you closer to the real net return on investment for the property. Cash flow before taxes considers all the expense items, even those that aren't cash out of pocket. Now you can see what you'll receive for cash flow before tax liabilities are taken into account.
Cash Flow After Taxes (CFAT)
This one is easy. It's CFBT minus taxes. The calculation for CFAT gets to the nitty gritty of what's left after everyone gets their cuts, even Uncle Sam, using the owner's or investor's tax rate exposure.
Debt Service Coverage Ratio (DSCR)
DSCR indicates whether a property is generating enough income to pay the mortgage. Find your debt service coverage ratio by dividing your NOI by your debt service. Using the $30,000 NOI figure again, we'll say that your debt service is $25,000 a year. You have a debt service ratio of 1.2.
Financing—or the lack of it—depends on this number.A ratio under 1.0 indicates that you are most likely going to be losing money each month. For example, a DSCR of 0.95 means there's only enough income to pay for 95% of annual debt payments. Lenders are more comfortable with ratios of 1.2 or more and are unlikely to provide loans at ratios that are less.
Breakeven Ratio
The breakeven ratio compares the property's gross income to its total expenses. To calculate it, add debt service to operating expenses, subtract money set aside for reserves, and divide by operating income to get yourbreakeven ratio.
This ratio is popular with lenders as well. They want to know when the propertywill have paid all expenses of operation and break out into profit for the remainder of the year. A ratio under 85% is considered good, though lender requirements vary and may depend on the type of property.
All of these tools can spell the difference between a solid investment and a cash-draining nightmare. It's never wise to jump in without doing at least a few calculations.
Frequently Asked Questions (FAQs)
What is the 2% rule in real estate?
This rule of thumb says if the monthly rent for a property is at least 2% of its total cost, it should produce positive cash flow for the investor. So, for example, if the total cost of the property is $300,000 and it rents for $6,000, the rent is 2% of the cost so you should consider buying.
But this rule should be taken with a large grain of salt. First of all, 2% properties are very hard to find. Secondly, it doesn't take into account local vacancy rates, property taxes, or maintenance required.
What's a good ROI for a rental property?
To calculate your annual return on investment (ROI) for a rental property, take your total income and subtract your mortgage payments and other monthly expenses. That's your annual return. To get your ROI, divide the annual return by your out-of-pocket expenses for the year (which might include a down payment, closing costs, and remodeling). That will give you your ROI.
What's considered "good" ROI depends on the property and the investor. It may range from 8% to 20%.
