Real estate formulas can help you make smarter investment decisions, guiding you whenever you decide to buy, sell, or retain properties. However, with investors using so many different formulas, it can be difficult to keep them straight and determine which ones you need. Don’t let all those formulas phase you. Whether you’re buying your first investment property or have a well-established portfolio, these are the real estate math formulas that you should know.
Net Operating Income = Operating Income − Operating Expenses
This formula helps you determine the income remaining after deducting operating expenses. These expenses may include the cost of maintaining and repairing your property, insurance premiums, and property taxes. Your net operating income (NOI) should always be a positive amount. If it’s not, you’re spending more than you can afford on your real estate portfolio.
Imagine you have a property that rents for $2,000 per month, without any vacancy loss. You have the following monthly property expenses:
- Repairs and maintenance: $200.
- Property management: $200.
- Property taxes: $150.
- Insurance: $100.
Adding these expenses, you find your total monthly expenses are $650. You now know your operating income is $2,000 and your operating expenses are $650. Using the formula, you subtract $650 from $2,000 to find your NOI is $1,350 a month, or $16,200 a year. If you own the property outright, this is the amount you can collect each month. If you have a mortgage, you can spend some or all of this amount repaying your debt.
Cap Rate = Net Operating Income/Purchase Price
Once you know your NOI, you can calculate the capitalization rate (cap rate). This rate tells you a property’s rate of return if it were paid for in cash. Investors use the capitalization rate formula to compare properties they’re interested in. This formula is helpful because it lets you compare properties consistently, without the variables of different loan deals. It can also help you track real estate trends. Properties with higher cap rates are riskier investments. A good capitalization rate depends on the area and its current real estate market.
For example, imagine you were considering buying one of two properties here in Boca Raton, Florida. Both properties have an NOI of $10,000 a year. One is an ultra-modern apartment in the downtown area. The other is a larger family home with more dated fixtures in the suburbs. If the apartment is $750,000, it would have a cap rate of 1.33% ($10,000/$750,000). If the family home’s price is $400,000, its cap rate is 2.5% ($10,000/$400,000). The family home is slightly riskier as an investment, although both cap rates are low.
Rent-to-Cost Ratio = Monthly Rent/Total Property Cost
Calculating the rent-to-cost ratio is another way to gauge whether a property is a good investment prospect. You can use this ratio when considering a single property or calculate the ratio for several properties to decide which is the best option. A property’s rent-to-cost ratio should be at least 1% for good cash flow.
For example, imagine you’re considering purchasing a $140,000 home that needs $10,000 of work before you rent it out for $2,000 per month. You add the $10,000 of work to the price of the home for a total property cost of $150,000. You then calculate the rent-to-cost ratio is 1.33% ($2,000/$150,000). As the ratio is greater than 1%, this property would offer good cash flow.
Cash-on-Cash Return = Cash Flow Before Taxes/Cash Invested
The cash-on-cash return formula tells you how much money your property gives you in the first year as a percentage of your cash investment. Calculating the cash-on-cash return can help you learn whether a property is a sound investment. You may retain properties with strong cash-on-cash returns and sell properties with lower cash-on-cash returns. Andrew Herrig, the founder of finance blog The Wealthy Nickel, recommends holding properties offering at least a 10% cash-on-cash return.
Imagine you purchased a three-bedroom home with a value of $250,000. You make a down payment of $20,000. Your NOI is $10,000 and your debt service is $7,500. Subtracting the debt service from NOI gives you $2,500 cash flow before taxes. You can then determine that your cash-on-cash rate is 12.5% ($2,500/$20,000) of your initial investment each year. Dividing 100% by the cash-on-cash rate shows you could pay back your entire investment in eight years.
Return on Equity = Annual Return/Total Equity
After the first year of ownership, you can’t accurately use the cash-on-cash return formula, as it doesn’t account for the time value of money. Using the ROE formula, short for return on equity, is a better option for evaluating property investments in the long term. Calculating the ROE for every property you own each year can help you make a smart decision about which ones to retain and which ones to sell. You can also use this formula to compare the performance of property against other investments, such as stocks.
While the formula itself is simple, calculating the parts involves some more complex calculations. You’ll find the annual return by adding yearly cash flow, appreciation, and principal paydown. Subtracting the rental property loan balance from the market value gives the total equity. You could use the ROE formula to calculate the ROE for the three-bedroom home in the previous example several years after its purchase. For example:
- Adding $2,500 cash flow with 5% appreciation ($12,500) and a principal paydown of $20,000 gives an annual return of $45,000.
- Subtracting the $230,000 loan balance from the home’s current value of $320,000 gives $90,000 total equity.
- The ROE is 38.89% ($35,000/$90,000).
Just like real estate formulas, Titan Funding can help you make the right investment decisions. We can help you access exciting real estate opportunities and offer advice as your portfolio grows. Contact us online or call our Boca Raton, Florida, office to learn more about how we can help you succeed in real estate.
House valuation document with small family house, calculator and magnifying glass on wooden table by Marco Verch Professional Photographer is licensed with CC BY 2.0