Using Formulas to Make Profitable Real Estate Decisions
We all have heard of Rate of Return or Rate of Investment but do you really understand how they apply to real estate investments? Those of you who have taken a Real Estate Class know to emphasize Cash after Debit Service, and touch on Capitalization Rate as two formulas that you need to understand when buying rental property. There is also return on Equity for those investors that have held assets for a long time and want to know what kind of return their equity is getting. Understanding how these formulas are calculated and what goes into them will help you better understand and analyze your investments.
ROR and ROI are the most frequently used formulas to analyze an investment. ROR/ ROI are the ratio of money made in relation to the investment made, also known as Capital. The money made will be referred to as the Return; this can be either interest paid or profit.
The ROR/ROI Formula is:
((Return-Capital)/ Capital) = Rate of Return
Example – Invest $200,000 in real estate and a year later the property is worth $250,000. The ROR/ ROI is 25%, calculated as follows: 250,000-200,000 = 50,000/200,000 = 25%
Most of the time Capitalization Rate is used for estimating the value of commercial income property, Capitalization Rate represents the projected return for one year, if you purchased the property with all cash. The Capitalization Rate formula is:
Operation Revenue – Operating Expense = (Net Operating Income) NOI / Sale Price.
Example – Property has a NOI of $250,000 and sales price of $2,250,000.
$250,000/$2,250,000 = 11.1% Capitalization Rate
Capitalization Rate is a useful formula to know when looking at commercial or rental property however it doesn’t take into consideration the debt, the cost of the debt or cash flow. The value of the investment and the ROR are important, but how much cash is going into the bank every month is a big factor. The formula used to find that out is, Cash after Debit Service. Cash after Debit Service uses actual income, all operating expenses and the cost of Debt Service. The Cash after Debit Service formula is:
Operating Revenue – Operating Expense = NOI – Debt Service= Cash after Debit Service
Example – An 8 unit apartment building has Operating Revenue of $4,600, Operating Expense is $2,495 making NOI $2,105 and Debt Service of $1,105 has Cash after Debit Service of $1000.00. $4,600-$2,495= $2,105- $1,105=$1000.00
Many investors who have owned investment properties for a long time have exhausted depreciation a major tax benefit; this in turn can create a poor annual return on their equity. To figure out what the return on equity is, we’ll use the following formula known as ROE.
The ROE formula is: Net Income/Estimated Net Equity = ROE,
a) Annual gross income = monthly rent(s) times 12.
b) Annual Expenses = all expenses including mortgage payment, insurance, taxes, maintenance.
c) Annual Net Income = A-B
d) Estimate the Net Equity of your property: Start with the Fair Market Value of the property then subtract the purchase price plus any capital improvements. These formulas are very important for real estate investors; they define what high-quality deals are and what deals that you should pass are.