“The general who wins the battle makes many calculations in his temple before the battle is fought. The general who loses makes but few calculations beforehand.” – Sun Tzu.
As an investor, I realize the importance of performing calculations prior to any investment. Before investing in any stock, or real estate, I run through a series of simple calculations to determine if an investment is worthwhile.
Unfortunately, many novice investors just take a hunch and dive right in without crunching the numbers and utilizing the simple mathematical skills given to us in grade school. Simple math, such as addition(+), subtraction(-), division(/), and multiplication(x) that could help any investor minimize risks while maximizing profits.
Please note that the financial ratios used will heavily depend on the type of investment and the accuracy of the data entered.
For today’s article, I would like to share with everyone my top 10 general calculations to perform before investing in any real estate:
Unless you have enough money to pay off the entire property, you’ll have to consider taking out a loan for your real estate investment. Therefore, one of the more critical ratios to consider is the LTV because it’ll affect the total amount you’ll pay to borrow the funds. In general, high LTV values are classified as “high-risk” and borrowers would typically either be charged more, or be required to purchase mortgage insurance, thus increasing your overall operating expenses.
Formula: Loan Amount x 100 / Market Value = LTV
Net Operating Income (NOI):
Any successful real estate investor would tell you the importance of calculating NOI. Not only does it take into account the property’s annual gross income less vacancies but also bad debt and total operating expenses. For those unaware, gross income includes any income associated with the property (e.g. rental, parking, laundry); operating expenses pertains to all costs incurred during the operating and maintenance of the property (e.g. repairs, insurance, utilities, property tax, management, etc).
Formula: Gross Income – Vacancy, Debt, Total Operating Expenses = NOI
Capitalization Rate (CR):
To determine the value of income producing properties, many investors calculate the CR as a gauge to estimate the purchase price for different types of income producing properties. In general, the higher the selling price, the lower the cap rate and the lower the selling price, the higher the cap rate.
As an investor, you would want your cap rate (%) as high as possible.
Formula: Net Operating Income / Sales Price (Value) = CR
Gross Rent Multiplier (GRM):
One of the easiest ways to determine a rough estimate of a property’s value is with the use of the GRM which only requires two pieces of information – the sales price and the total amount of gross rent possible. You could calculate the GRM on a monthly basis, or yearly, and it’ll give you a good gauge on how much cash flow the property is capable of producing.
Formula: Purchase Price / Annual Gross Rent = GRM
Debt-Cover Ratio (DCR):
The DCR is another vital ratio used to measure a property’s ability to pay back its mortgage and other operating expenses. From an investor’s perspective, the larger the DCR value, the better and a DCR ratio of 1 equates to “break-even.” Typically, many lenders and banks require a DCR value of 1.1 – 1.3 prior to approving loans.
Formula: NOI / Debt Service (Total Principal & Interest Annually) = DCR
Break-Even Ratio (BER):
The BER is used to compute the ratio between a property’s cash out flow and rental income to determine what percentage is outgoing compared to income. Typically, many lenders and investors look for a BER value of
Formula: Debt Servicing + Annual Operating Expenses / Gross Operating Income = BER
Return on Investment (ROI):
To be a successful investor, you must determine your ROI to ensure that you receive profits from your investment(s) after deducting all associated costs and expenses. Not only would the ROI help to evaluate the profitability of an investment but also its efficiency and effectiveness in relation to other properties or investments.
Formula: Gain from investment – Cost of Investment / Cost of Investment = ROI
Cash-On-Cash Return (CCR):
The CCR is a percentage measuring the return on the cash invested in a rental property.
Formula: Cash Flow Before-Taxes / Cash Invested x 100 = CCR
Of course, not all real estate investments will be short-term flips. There are some properties that you’ll want to hold onto for the long-term in an effort to take advantage of appreciation because you feel that these properties will be worth much more in the future. Rather than getting instant gratification through a quick sale, you could keep the property and gradually make improvements in an effort to increase rent. Remember, many investors would gladly pay more for a property with a high ROI and appreciation.
Formula: Future Resale Price – Original Sales Price = A
Depreciation is another important consideration when investing in real estate. To calculate basic depreciation, investors must know the initial cost of the asset and it’s salvage value, including estimated “useful life.”
Formula: Cost – Salvage Value / Estimated Useful Life = D
To illustrate, let’s say that an investor purchased a property for $100,000 and it’s useful life was determined to be 10 years, then the property depreciates in value by $10,000 annually.
Henry Ford once said that “the best we can do is size up the chances, calculate the risks involved, estimate our ability to deal with them, and then make our plans with confidence.” By using the 10 calculations mentioned above, you could crunch the numbers to eliminate the guess work with any real estate investment and approach each deal with confidence!