Let’s be honest; there aren’t many people who love math. Those that do can be found adorning university halls and classrooms, not the real estate market. However, there is plenty of math involved in real estate investing. The difference is that a mathematician may practice math out of sheer passion, real estate investors practice math out of necessity to calculate the returns on their investments.
What type of math do real estate investors need to know? Several formulas will help you determine optimal outcomes for your properties.
Real Estate Investment Formulas to Know
Net Operating Income
The first and most basic formula to know is net operating income (NOI). Calculate this formula by subtracting your total expenses from the monthly or annual gross income. Gross income will come from rent payments, vending machines, parking spaces, etc. The total operating expenses are the expenses required to continue operating the property, such as salary for a property manager, routine maintenance, gardeners, etc.
Net Operating Income = Gross Income – Total Expenses
The capitalization rate, or cap rate, is the property’s annual net operating income and market value ratio, typically represented as a percentage. Ideally, you want to maximize the cap rate whenever possible. For instance, say you purchase a $400,000 property with NOI of $20,000. The cap rate would be 5%. This is simply an example to illustrate the point.
Cap Rate = Net Operating Income / Market Value for Property x 100%
Debt Service Coverage Ratio
The debt service coverage ratio is the ratio of NOI to annual debt service. This formula can be used as a metric to determine how lucrative an investment may be. Lenders will often use this metric to decide on the maximum loan amount they can offer.
Read all about DSCR here in our previous post.
Debt Service Coverage Ratio = NOI / Debt Service
For Home Flippers: 70% Rule
The 70% rule works surprisingly well as a quick, back-of-the-envelope formula. To calculate the 70% rule, divide a property’s price by the after-repair value and multiply by 100%. This metric takes some experience in the industry to assess what the after-repair value might come out to be. However, once you have a solid grasp of a property’s after-repair value, you can use the 70% rule to determine the purchase price for you to yield a worthwhile return.
For example, let’s say you spot a property for sale in a neighborhood where 2,000 square foot, newly-renovated homes have been selling for $500,000. The property you’re eyeing needs some renovations, so the seller is asking a price below the prices of the comparable sales. Using the 70% rule, you calculate that you should pay approximately $350,000 for the home. This will give you enough margin to make the necessary renovations and sell it at a price the market will tolerate. If the seller is asking $450,000, it might not be worth your while as a fix-and-flip project.
70% = Home Purchase Price / After-Repair Value x 100%
For Rental Property Owners: 1% Rule
The 1% rule is only a guideline, so take it with a grain of salt. Essentially, it can be used to calculate monthly rental rates on your property. If you own a $200,000 property, the 1% rule dictates that you can charge 1%, or $2,000, in monthly rent.
1% = Monthly Rental Income / Property’s Value
The 80/20, or Pareto’s, principle is a statistical rule that states that 80% of results are achieved through 20% of the effort. While this doesn’t apply only, or even directly, to real estate, the idea behind the principle is that one can achieve most of the results with focused and intentional effort. If you can identify where you achieve most of your results in real estate investment, you might find that it only uses 20% of resources, and you can apply the other resources elsewhere to yield better results.
80/20 = 80% of results are obtained from 20% of the effort
Learn These Formulas and Make Better Decisions
The goal here isn’t math for fun – it’s to make better investment decisions. Apply these formulas where and when you can so that you don’t have to make any guesses. Want to calculate what financing looks like for your next real estate venture? Check out our calculator to get started.