Real Estate Investing

Real Estate Investment Calculations

If you’re considering investing in real estate rental property, there is a lot of research to do. You should also be sure that you’re suited to being a landlord, and that you have the time to manage properties. However, all that aside for now, what we want to do here is to examine the way that a property generates cash flow from rental operations.

For our example, we’ll use a fourplex, with all four units being destined for full-time rental. This is a simple cash flow calculation to illustrate the potential of real estate as an investment. Critical to this, as with most investments, is an intelligent and well-researched purchase on the front end. We’ll assume for our example that this buyer did their research and made a good buy on our fourplex. Here are the purchase and rental particulars:

  1. Purchase price of the fourplex is $325,000.
    2. Buyer places 20% down, or $65,000, financing $260,000.
    3. 30 year loan is at 6.5%, with Principle/Interest payment of $ 1643 per month.
    4. Taxes and insurance at purchase are $3600/year, for total payment of $1943 per month.

The buyer did their research and sees a steady rental demand for these units, all of which stay occupied most of the time. However, to be prudent in their calculations, a 6% vacancy and non-payment risk will be calculated to anticipate real cash flow. The units are all identical and rent for $900 per month each. Let’s see how our calculation breaks down:

  1. Gross rental income is $900 X 4 X 12 months, or $43,200 per year.
    2. Payments are $1943 X 12 = $23,316 per year.
    3. Previous owner’s repair expense has averaged $1700 per year.
    4. Vacancy and credit loss is estimated at 6% of rents or $2592 per year.
    5. Owner spends about $400 each year in miscellaneous and advertising costs, and manages the property on their own.

Those are the basic operational items that go into our cash flow calculation. Let’s take our calculation to the profits:

  • Rent income – Vacancy Loss – Payments – Expenses = Cash Flow
  • $43,200 – $2592 – $23,316 – $2100 = $15,192 / 12 = $1266 per month in positive cash flow.

Analyzing your return as “cash on cash invested”, you would divide your actual cash investment of $65,000 down into the annual return of cash, or $15,192. This is a yield of 23% on your cash invested! There are few investments out there that yield this kind of return. Check out the rest of this rental property investment series to see the other ways in which this example property provides tax and other incentives and returns.

 

  1. Gross Potential Income

Gross potential income is the expected income a property will produce without deductions for expected vacancy or credit loss.

This one is relatively simple. We want to know what income will be realized if a property is fully occupied and all rents are collected. We take number of units times annual rent for a total.

Example: An apartment complex with six units. Three rent for $700 per month and the other three rent for $800 per month.

 

  1. Gross Operating Income

This calculation takes into account losses due to vacancy and non-payment.

Once we know the Gross Potential Income of a real estate investment property,we arrive at the Gross Operating Income by subtracting out the estimated annual losses due to non-payment or vacancies.

  1. Let’s use our already calculated Gross Potential Income result of $54,000. This is if all units are full and all rents paid.
  2. Based on experience, the current market and rental occupancies, we estimate that our losses due to vacancies and non-payment will be 5%.
  3. $54,000 *.05 = $2700
  4. $54,000 – $2700= $51,300 for our Gross Operating Income

 

  1. Gross Rental Multiplier

Though not the most precise of tools, the GRM can give you a quick comparison tool to decide on whether to do a more thorough analysis.

As a real estate agent working with real estate investors, you will likely be doing quite a few market value analysis for each property finally purchased. The Gross Rental Multiplier (GRM) is easy to calculate, but isn’t a very precise tool for ascertaining value. However, it is an excellent first quick value assessment tool to see if further more detailed analysis is warranted. In other words, if the GRM is way out high or low compared to recent comparable sold properties, it probably indicates a problem with the property or gross over-pricing.

  • Getting the GRM for recent sold properties:

Market Value / Annual Gross Income = Gross Rent Multiplier (GRM)

Property sold for $750,000 / $110,000 Annual Income = GRM of 6.82

  • Estimating value of property based on GRM:

Let’s say that you did an analysis of recent comparable sold properties and found that, like the one above, their GRM’s averaged around 6.75. Now you want to approximate the value of the property being considered for purchase. You know that its gross rental income is $68,000 annually.

GRM X Annual Income = Market Value

6.75 X $68,000 = $459,000

If it’s listed for sale at $695,000, you might not want to waste more time in looking at it for purchase.

 

  1. Net Operating Income

Here we throw in the operating expenses, such as management, repairs, janitorial, etc. for our NOI.

As a real estate professional serving investment clients, you need to be very familiar with all the methods of valuation of income properties. One of these is the calculation of Net Operating Income, as it is used with cap rate to determine the value of a property.

  1. Determine the Gross Operating Income (GOI) of the property:

Gross Potential Income – Vacancy and Credit Loss = Gross Operating Income

  1. Determine the operating expenses of the property. This would include expenses for management, legal and accounting, insurance, janitorial, maintenance, supplies, taxes, utilities, etc.
  2. Subtract the operating expenses from the Gross Operating Income to arrive at the Net Operating Income. Using the example of a property with a gross operating income of $52,000 and operating expenses of $37,000, our net operating income would be:

$52,000 – $37,000 = $15,000 Net Operating Income

 

  1. Capitalization Rate

By using other properties’ operating income and recent sold prices, the capitalization rate is determined and then applied to the property in question to determine current value based on income.

Those who invest in real estate via income-producing properties need to have a method to determine the value of a property they’re considering buying. By using other properties’ operating income and recent sold prices, the capitalization rate is determined and then applied to the property in question to determine current value based on income.

  1. Get the recent sold price of an income property, such as an apartment complex.

Example: Six unit apartment project sold for $300,000

  1. For that same apartment project, determine the net operating income, or the net rentals realized by the owners.

Example: The rental income after expenses (net) is $24,000

  1. Divide the net operating income by the sale price to get cap rate.

Example: $24,000 / $300,000 = .08 or 8% (The Capitalization Rate)

 

  1. Cash Flow Before Taxes (CFBT)

We take net operating income and subtract capital cash expenditures as well as debt service, add back loan proceeds and interest income.

When you work with real estate investor clients, it’s important that you have the knowledge to help them determine the viability of investments. Cash flow is quite important, as it disregards the deductibility for tax purposes of expenses. A tax return tells you some things, but cash flow tells you more.

  1. Begin with the Net Operating Income of the property.
  2. Subtract the money out for debt service. This is the amount spent for the entire mortgage payment, interest and principle.
  3. Subtract any capital expenditures. This would be money spent for improvements on the property, whether they are deductible that year or not. This is actual cash spent.
  4. Add any loan proceeds. This is the money borrowed on a loan other than the original mortgage. If you made capital improvements, but took out a loan to pay for it, put that loan amount here as an addition.
  5. Add any interest earned. Should the property have loans or investments out that provide cash in as interest, add that in here.
  6. You have now come to the result, which is the Cash Flow Before Taxes (CFBT) for this property. Here’s the line itemization:

Begin with Net Operating Income
– Subtract Debt Service
– Subtract Capital Improvements cash out
+ Add Loan Proceeds for loans to finance operations
+ Add back any interest earned
= Cash Flow Before Taxes

 

  1. Cash Flow After Taxes (CFAT)

This one is easy, as it’s the CFBT with taxes subtracted.

Cash flow after taxes isn’t a difficult calculation. Once Cash Flow Before Taxes is determined, it’s a simple matter to subtract tax liability to determine Cash Flow After Taxes. It’s possible that, due to accrued losses deductible in later years, that this after tax cash flow could actually be a positive number and be higher than the cash flow before taxes.

  1. Determine the cash flow before taxes.
  2. Subtract the income tax liability, state and federal.

The result is the Cash Flow After Taxes.

  1. Another method of calculating CFAT is:

CFAT = Net Income + Depreciation + Amortization + Other Non-Cash Charges

They really aren’t that different, as you’re just adding back cash items that were subtracted for the Cash Flow Before Taxes calculation. In the CFBT calculation, debt service is subtracted from Net Income, as it’s a cash outflow. However, the depreciation and interest are both deductible for taxes, and thus are added back to get the CFAT.

 

  1. Break-Even Ratio

Add Debt Service to Operating Expenses and divide by Operating Income.

Lenders use the break-even ratio as one of their analysis methods when considering providing financing for a real estate investment property. Too high of a break-even ratio is a cautionary indicator.

  1. Determine the debt service for the property.

In this case we’ll assume an annual debt service of $32,000

  1. Determine the annual operating expenses for the property.

In this case, we’ll assume that management and direct operating costs annually are $47,000.

  1. Calculate the annual gross operating income of the property.

We’ll assume a gross operating income of $98,000 annually.

  1. Add Debt Service to Operating Expenses and divide by Operating Income:

$32,000 + $47,000 / $98,000 = .81 or an 81% Break-Even Ratio.

 

  1. Return on Equity – Year One

This is the percentage return on your cash investment the first year.

Many real estate investors are involved in multiple properties and use leverage in their purchases. When deciding on the viability of an investment, one of the measures used is the expected Return on Equity in the fist year.

If two properties are similar, the one which will produce the best first year return may be the better short term investment.

  1. Determine the Cash Flow After Taxes. In this case, we’ll assume a CFAT of $11,000.
  2. What is the cash invested as down payment or other into acquiring the property? We’ll use $170,000 in this example.
  3. Divide the CFAT by the cash invested:

$11,000 / $170,000 = .065 or 6.5% Return on Equity

 

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