For today’s article, I’d like to share with all of my top 10 general calculations to perform before investing in any real estate:
Loan to value (LTV):
Unless you have enough money to pay for the entire property, you will need to consider taking out a loan for your real estate investment. Therefore, one of the most critical reasons to consider is the LTV because it will affect the total amount you will pay to borrow the funds. Generally, high LTV values are classified as “high risk” and borrowers will 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 gross annual income of the properties minus the vacancies, but also the bad debts and the total operating expenses. For those of you 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: Vacancies, Debts, Total Operating Expenses = NOT ME
Capitalization rate (CR):
To determine the value of income-generating properties, many investors calculate CR as an indicator to estimate the purchase price of different types of income-generating properties. In general, the higher the selling price, the lower the capitalization rate, and the lower the selling price, the higher the capitalization rate.
As an investor, you want your capitalization rate (%) to be as high as possible.
Formula: Net operating income / selling price (value) = CR
Gross Rent Multiplier (GRM):
One of the easiest ways to determine a rough estimate of the value of a property is with the use of the GRM, which only requires two pieces of information: the sale price and the total amount of possible gross rent. You can calculate the GRM on a monthly or yearly basis, and it will give you a good indicator of how much cash flow the property is capable of producing.
Formula: Annual gross purchase / rental price = GRM
Debt coverage ratio (DCR):
The DCR is another vital index 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 interest annually) = DCR
Equilibrium ratio (BER):
The BER is used to calculate the relationship between a property’s cash outflow and rental income to determine what percentage is issued compared to income. Typically, many lenders and investors look for a BER value of <85%. The reason is that they want some kind of guarantee in case the rents go down ~ 15% before the property is repossessed.
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 Profit – Investment Cost / Investment Cost = KING
Cash Over Cash Return (CCR):
The CCR is a percentage that measures the return on cash invested in a rental property.
Formula: Cash flow before tax / cash invested x 100 = CCR
Of course, not all real estate investments will be short-term investments. There are some properties that you will want to keep long term in an effort to take advantage of appreciation because you feel 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 increase the rent. Remember, many investors would gladly pay more for a property with a high return on investment and appreciation.
Formula: Future Resale Price – Original Sale Price = FOR
Depreciation is another important consideration when investing in real estate. To calculate basic depreciation, investors must know the initial cost of the asset and its salvage value, including the estimated “useful life”.
Formula: Cost – Salvage Value / Estimated Lifetime = D
To illustrate, let’s say an investor purchased a property for $ 100,000 and its useful life was determined to be 10 years, then the property depreciates in value by $ 10,000 annually.
Henry Ford once said that “the best we can do is evaluate the possibilities, calculate the risks involved, estimate our ability to cope with them, and then make our plans with confidence.” By using the 10 calculations mentioned above, you could do calculations to take the guesswork out of any real estate investment and approach each deal with confidence.