There are many different real estate calculations used in the analysis of properties and their performance, but for many beginner investors it can be confusing to know which formulas to use, when to use them and why use them. Many of these formulas are used when analyzing single properties and multi-family properties.
Presented below are the more popular real estate calculations, explain their purpose and include the formula.
Capitalization Rate (CR): The Capitalization Rate or Cap Rate is a ratio used to estimate the value of income producing properties. Put simply, the cap rate is the net operating income divided by the sales price or value of a property expressed as a percentage. Investors, lenders and appraisers use the cap rate to estimate the purchase price for different types of income producing properties. A market cap rate is determined by evaluating the financial data of similar properties, which have recently sold in a specific market. It provides a more reliable estimate of value than a market Gross Rent Multiplier since the cap rate calculation utilizes more of a properties financial detail. The GRM calculation only considers a property’s selling price and gross rents. The Cap Rate calculation incorporates a property’s selling price, gross rents, non-rental income, vacancy amount and operating expenses thus providing a more reliable estimate of value.
If we have a seller and an interested buyer for particular piece of income property, the seller is trying to get the highest price for the property or sell at the lowest cap rate possible. The buyer is trying to purchase the property at the lowest price possible, which translates into a higher cap rate. Rules of thumb: The lower the selling price, the higher the cap rate; the higher the selling price, then the lower the cap rate. In summary, from an investor’s or buyer’s perspective, the higher the cap rate, the better.
Formula:
| NOI NOI |
| Cap Rate = ——— Estimated Value = ————- |
| Value Cap Rate |
Debt Cover Ratio (DCR): Another important ratio that is used to evaluate income-producing properties is the Debt Coverage Ratio or DCR. The NOI is a key ingredient in this important ratio also. Lenders and investors use the debt coverage ratio to measure a property’s ability to pay its operating expenses and mortgage payments. A debt coverage ratio of 1 is breakeven. Most lenders require a minimum of 1.1 to 1.3 to be considered for a commercial loan. From a bank’s perspective and an investor’s perspective, the larger the debt coverage ratio, the better. Debt coverage ratio is calculated like this.
Formula:
| Net Operating Income 50,000 |
| Debt Coverage Ratio = —————————— = ——————— = 1.25 |
| Debt Service 40,000 |
Debt service is the total of all interest and principal paid in a given year. It is equal to the mortgage payment times 12 or the mortgage payments times 12 if you have multiple loans on a property.
Effective Gross Income (EGI) or Gross Operating Income (GOI):
Effective Gross Income equals potential gross income minus the vacancy amount.
Income
Gross Potential Rent: $100,000
Other Income: $3,000
Potential Gross Income: $103,000
Less Vacancy Amount: $2,000
Effective Gross Income: $101,000
Gross Potential Rent (GPR):
Gross potential income is the expected income a property will produce assuming it is 100% occupied and the full rent is received every month.
Example: a suite renting for $800 per month provides a GPR of $9,600.
Gross Realized Rent (GRR): Gross realized rent is the gross potential rent (the rent which would be collected if all units were leased at market rents) less an allowance for vacancy and bad debt.
Gross Rent Multiplier (GRM): The Gross Rent Multiplier or GRM is a ratio that is used to estimate the value of income producing properties. The GRM provides a rough estimate of value. Only two pieces of financial information are required to calculate the Gross Rent Multiplier for a property, the sales price and the total gross rents possible. If this information is available for multiple sales of similar types of income properties in a particular area, it can then be used to estimate the market value of other similar properties in that area. Some investors use a monthly Gross Rent Multiplier and some use a Yearly GRM. The Gross Rent Multiplier is equal to the Sales Price of a property divided by the potential gross income and the Yearly GRM is the Sales Price divided by the yearly potential gross income.
Formula:
| Sales Price |
| GRM = ——————————————- |
| Gross Potential Rental Income |
A market GRM can provide a rough estimate of value when consistent and accurate financial information is available for sales of similar types of properties in a particular market place, but it does have some limitations. Operating expenses, debt service and tax consequences are not included in the GRM calculation. We could have a situation where two properties have approximately the same potential gross income, but one property has significantly higher operating expenses. The above formula would result in a questionable estimation of the market value for these properties. Also, the above GRM formula uses the potential gross income and doesn’t account for a vacancy factor, which could have an impact on the accuracy of the property value estimates. This is why it is important to have accurate and detailed financial information for comparable sales when establishing a market GRM or Cap Rate for income producing properties.
The GRM is sometimes calculated using the effective gross income rather than the potential gross income thus incorporating the vacancy factor in the GRM calculation. Effective Gross income equals potential gross income minus the vacancy amount. When vacancy rates are a factor, using the effective gross income will produce a more reliable estimate.
The capitalization rate is a more reliable tool for estimating the value of income producing properties since vacancy amount and operating expenses are included in the cap rate calculation. The GRM is useful in providing a rough estimate of value.
Net Operating Income (NOI): Net Operating Income or NOI is equal to a properties yearly gross income less vacancy allowance, bad debt allowance and total operating expenses. Gross income includes both rental income and other income such as parking fees, laundry and vending receipts, etc. All income associated with a property. Operating expenses are costs incurred during the operation and maintenance of a property. They include repairs and maintenance, insurance, management fees, utilities, supplies, property taxes, etc. The following are not operating expenses: principal and interest, capital expenditures, depreciation, income taxes, and amortization of loan points. Net operating income is calculated like this.
Income
Gross Rents Possible: $100,000
Other Income: $3,000
Potential Gross Income: $103,000
Less vacancy Amount: $2,000
Effective Gross Income: $101,000
Less Operating Expenses: $31,000
Net Operating Income: $70,000
Net operating income or NOI is used in two very important real estate ratios. It is an essential ingredient in the Capitalization Rate (Cap Rate) calculation that is used to estimate the value of income producing properties. Let’s assume we have a market capitalization rate of 10 for the type of property we are considering purchasing. A market cap rate is calculated by evaluating the financial data from current sales of similar income producing properties in a given market place. We are evaluating a similar income property that is currently for sale with a net operating income of $70,000. We would estimate the value of this property like this.
Formula:
| Net Operating Income 70,000 |
| Estimated Value = —————————- = ———————- = 700,000 |
| Capitalization Rate .10 |
Net Rent Multiplier (NRM): Like the GRM the NRM is used for the evaluation of a property or comparison between properties. Net Rent Multiplier is a more accurate measure than the Gross Rent Multiplier because it accounts for the operating expenses of the property in its equation to determine the value. The Net Rent Multiplier only assumes that the net operating income is stable and perpetual whereas the GRM assumes both the Gross Potential Rent and the operating expenses are stable and perpetual.
Formula:
| Sales Price |
| NRM = ——————————————- |
| Net Operating Income |
Return On Investment (ROI):
Return on Investment is a performance measure used to evaluate the efficiency or profitability of a property or investment within itself and in relation to other properties or investments. The accuracy of the ROI measurement is dependent on the accuracy of the data used to calculate the ROI. Therefore the more accurate the data the more accurate the end result.
Example:
Total Down payment: $350,000
Income
Gross Rents Possible: $100,000
Other Income: $3,000
Potential Gross Income: $103,000
Less vacancy Amount: $2,000
Effective Gross Income: $101,000
Less Operating Expenses: $31,000
Net Operating Income: $70,000
Less Finance Interest: $35,000
Net Income: $35,000
Formula:
Net income 35,000
Return on Investment = ——————————- = ———— = .1 or 10%
Total Down Payment 350,000
Return On Equity (ROE): Return on Equity and Return on Investment mean the same thing and are used and interchangeable.
Cash on Cash Return (CCR): Cash on Cash Return is a percentage that measures the return on cash invested in an income producing property. It is calculated by dividing before-tax cash flow by the amount of cash invested and is expressed as a percentage. If before-tax cash flow for an investment property is equal to $15,000 and our cash invested in the property is $100,000, cash on cash return is equal to 15%.
Formula:
| Before-Tax Cash Flow $15,000 |
| Cash on Cash Return = —————————— X 100 = ————- X 100 = 15% |
| Cash Invested $100,000 |
|
| The following shows how before-tax cash flow is derived. |
|
| Gross Income: $54,500 |
Less Vacancy Amount: $2,500
|
| Gross Operating Income: $52,000 |
| Less Operating Expenses: $17,000 |
| Net Operating Income: $35,000 |
Less Annual Debt Service: $20,000
|
| Before-Tax Cash Flow: $15,000 |
Cash on Cash Return is used to evaluate the profitability of income producing properties. It can be useful when comparing investment properties, but is just one of many analysis tools. It only considers before-tax cash flow and doesn’t take into account an investor’s individual income tax situation and it doesn’t consider the wealth building potential of a property via appreciation. A property in one area of a city may have a better Cash on Cash Return then a property in another location, but it may not appreciate as fast because of its location. One location may be more desirable than the other.
Cash Flow Before Taxes (CFBT)
Cash flow before taxes is a very important number to determine as this can determine how profitable the property will be prior to the tax implications. Every person has a different set of circumstances, therefore determining the CFBT can assist with developing tax reduction strategies. One begins with the Net operating Income and then deduct the entire mortgage payment (principle and interest). Also all the capital expenditures (money spent on property improvements) whether they are deductible in the current year or not. This is actual money spent. If you have borrowed any funds for the capital expenditures or additional financing other than the original mortgage then you must add this amount back into the calculation. Finally if any interest was earned through the property then this must also be added into the calculation to determine the CFBT.
Example:
Net Operating Income $70,000
Less Mortgage Payments $45,000
Less Capital Expenditures $15,000
Plus Additional Financing $5,000
Plus Interest Earned $2,000
Cash Flow Before Taxes $17,000
Cash flow After Taxes (CFAT)
Cash flow after taxes is only different from the Cash flow before taxes in that you now deduct the applicable taxes to determine your final figure.
Example:
Net Operating Income $70,000
Less Mortgage Payments $45,000
Less Capital Expenditures $15,000
Plus Additional Financing $5,000
Plus Interest Earned $2,000
Cash Flow Before Taxes $17,000
Less Associated Taxes $3,400 (assuming a 20% for demo purposes)
Cash Flow After Taxes $13,600
Break-Even Ratio (BER):
The break-even ratio is used by banks and lenders as one of their analysis methods when considering providing financing for a real estate investment property. If the break-even ratio is too high in their perspective then they may be reluctant to lend on the property. In short to determine the break-even ratio the debt servicing is added to the annual operating expenses and then divided by the gross operating income or Effective Gross Income. Because the BER computes the ratio between the property’s cash out flow and rental income, this percentage demonstrates what percent is outgoing compared to the income. As a rule of thumb, lenders look for a BER of 85% or less. That is, they want the assurance that rents can decline 15% before the property breaks even.
Formula:
| Debt srvc. + Ann. Op. Exp. $45,000 + $31,000 |
| BER = ——————————- = ———————————- = .753 |
| Gross Operating Income $101,000 |
Translated this means that this property would have a 75.3% Break-even ratio or the property’s income would have to decrease over 24% before it would hit the break-even point.
