Systems and habits make good friends, and they help real estate investors make good decisions. There are many ways an investor can quickly assess the potential value of buying a particular property. These 4 calculations are the main ones real estate investors should know and use. To keep it simple, you will:
- Buy a property, probably with a loan.
- Spend money fixing it up
- Service the debt.
- Take in rental income.
By using these factors to calculate a property's worth, you make good decisions. Let's break them down.
1. Gross Yield
This is a big one. Take the expected rental income (RI) and divide it by the total cost of buying and renovating the property. So if the annual rent is $24,000, and the cost of purchase plus renovation, is $315,000, then the Gross Yield is 0.076 (24,000 divided by 315,000.) Multiply that by 100, and the gross yield is 7.6%.
The Gross yield must be a high enough figure to make it worth investing the money, putting in the renovation work, and management time and costs, so a quick calculation is:
NOI/Total Cost X 100 = Gross Yield Percentage.
2. Debt Service Ratio
You borrow money to buy and fix the property, so you must service that debt. The net income (gross rent minus direct costs) must be worthwhile. Take the monthly Net Operating Income (NOI) and divide it by the principal and interest (PI) you pay on the loan. You need an answer greater than 1. If your NOI is $17,000 and your PI is 14,600, the ratio is 1.16.
NOI/PI = Debt Service Ratio
This calculation helps to determine the cash flow on a property you are considering. The property has a tenant paying a monthly rent of $1,200 (MR.) You intend putting down a deposit of $30,000, and your closing costs are $5000, then your total cost (TC) is $35,000. Divide 1,200 by 35,000 and you get a Rent/Cost ratio of 0.034, or 3.4%. Anything over 1.5 is good. It does depend on the area, so find out what other similar rental properties are producing and compare your calculation with what you know or what your real estate professional can tell you.
MR/TC = Rent/Cost Ratio
4. Cash on Cash
This is a simple and very important calculation. It tells you about the return you will get. It does not take into account any tax benefits or property appreciation in the long term. Take your annual cash flow. Cash flow (CF) is your NOI minus your debt service (cash in minus cash out) divided by your total initial cash investment (TC.) If NOI is $17,000 and PI is $14,600, the CF is $2,400. You put down $35,000, so your Cash on Cash figure is 6.8%.
For residential rental investments, as opposed to commercial, these four calculations are important to your basic decision, and easy to do. When you are ready to talk with us about your loan requirements, please just click here to contact us.