No investment makes sense without a preliminary assessment of return on investment and profit. Otherwise, it is a drain of money into the sewer. Assessing the attractiveness of buying real estate also has its own characteristics. You need to use different real estate calculations to evaluate the potential profitability of commercial or residential real estate, as well as take into account other factors specific to this market. In this article, we have compiled the ten most important formulas without which the assessment of the profitability of real estate investment becomes impossible.
Rent to Cost indicator is calculated as a monthly rate cost divided by total cost.
Perhaps this is the very first and most important formula that you need to remember. This indicator is ideal for comparing several objects, but it cannot serve as an unambiguous factor for making a decision.
In addition, you still need to know that the cheaper the property, the higher the rent to cost it will have. At the same time, it is important to leave for consideration only those properties that show rent to cost higher than one percent. For example, if the cost of a particular object is $75,000, and the monthly rental price is $900, then rent to cost will be 1.2%. ($900 / $75,000).
2. Gross Rent Indicator
Gross Rent Indicator is the relation between the total cost of real estate and gross annual rents.
This ratio is used to assess the profitability of real estate from an annual perspective. Moreover, this rule also works if you take into account not only the initial cost but also the expenses necessary for the repair of the premises. However, please note that this indicator does not include operating expenses. In this case, the lower the coefficient the better.
For example, if we take the figures from the previous paragraph, we will get a 6.9% gross rent indicator ($ 75,000 / ($ 900 * 12)).
3. Capitalization Rate
The capitalization index is calculated as net operating profit divided by the total value of the real estate and multiplied by 100.
This is one of the key commercial real estate formulas to evaluate the reasonability of investments and it is used when you need to compare several commercial objects.
The idea of calculating this index is that we can assume and model the situation when you buy several objects for cash. A higher coefficient, in this case, means a lower selling price for the same amount of income.
4. Debt Service Coverage Rate
This indicator is calculated as net operating income divided by annual debt servicing expense.
This investment property formula makes sense when you invest borrowed money. In simple words, this indicator indicates whether the property has sufficient potential to cover your debt plus profit. This formula is also used by banks to calculate the likelihood of successful loan repayment by the borrower. Most financial institutions want this figure to be at least 1.2% – be guided by this figure when you make a purchase decision.
5. Break-Even Ratio
Break-Even Ratio is calculated as the sum of operating expenses and debt services divided by gross income.
This indicator is also used when it is necessary to take a loan to buy a property. In this case, the higher the breakeven ratio, the better. This metric answers the question of how the percentage of gross income relates to your total expenses.
6. The 50% Rule
This is more of a rule than a formula, but you still need to know this. This rule says that your estimated annual operating expenses will be half of the gross rental income. This formula allows you to immediately see how much you need for operating expenses and allows you to take into account both real numbers and your expectations. This rule is especially true for residential apartments, and it makes sense to evaluate this indicator also in the context of capitalization index and debt service coverage rate.
7. Cash on Cash Return
This indicator can be found if you take your cash flow before the taxes are paid and divide this sum by the sum of invested cash.
In order for your property to be profitable, this figure should be at least 10%. This is an important indicator because a small margin within this percentage can protect you from market fluctuations. The higher this indicator, the lower the risk that in the event of a crisis you will be forced to pay for your investment object from your pocket instead of covering all expenses and continuing to make a profit.
8. Price Per Square Foot
In order to calculate this figure, you do not even need to graduate from college. It is even not necessary to seek help from professionals from Pick The Writer or Writing Judge. Just divide the value of your property by its total area.
You need this indicator in order to navigate the market well and understand what factors automatically increase the value of the real estate, and the cost of its rent, respectively. And this is one of the first indicators with which you need to start your comparative analysis.
9. 70% Rule
This is a mandatory rule for study for those who want to invest extremely profitably (and sometimes even aggressively). It says that the amount you must pay for the property should be 70% of the repair cost minus rehab costs. In other words, this rule gives you the opportunity to clearly determine whether you will become a victim of fraud.
However, the modern residential real estate market is such that it is practically impossible to sign a deal that will comply with 70% of the rule – 80% is much closer to reality. But you already know about this subtlety.
10. Return on Equity
You need this formula to review the potential profitability of the property you own annually. This is calculated as your annual income divided by the cost of capital (that is, the amount that you will receive if you sell the property in the current market conditions). Basically, this indicator should be more than 20%. In the case of a smaller result, perhaps it will make sense to think about selling and reinvesting in another object.
As you can see, not everything is so complicated with the assessment of potential profitability from investments in real estate. Use all these formulas to get a real picture that reflects all aspects.
Thomas Lore is a 23-year old writer. He is also a creative and diligent freelance blogger, who is always seeking for new ways to improve himself. Thomas is very versatile and he wants to reach the tops with his writing skills.