Real estate investment formulas help investors make more informed decisions about the financial risks and benefits associated with a property.
By using these simple formulas, you can:
- Determine the potential profitability of an investment
- Compare different opportunities
- Target specific types of investments that best align with your goals
Let’s look at the top real estate investment formulas that every investor should know.Get started with Park Place Finance.
1. Net operating income (NOI)
NOI helps investors evaluate a property’s income potential after deducting operating expenses.
NOI = Total Property Revenue – Operating Expenses
Total property revenue includes all of the revenue generated from renting out the property, which mostly comes from monthly rent payments from tenants.
Operating expenses are the costs associated with operating and maintaining the property, including:
- Property management fees
- Property taxes
- Maintenance costs
By subtracting operating expenses, NOI provides a clear picture of the property’s financial health.
If a rental property generates $120,000 in total property revenue annually and has $40,000 in operating expenses, NOI would be calculated as follows:
$120,000 – $40,000 = $80,000
This property has an NOI of $80,000 after covering operating expenses.
Investors can use NOI to compare properties, and this figure also is used in other real estate formulas such as cap rate.
Capitalization rate or cap rate is a key formula used to evaluate the potential return on an investment property.
Cap Rate = (NOI / Current Market Value) x 100
A property’s current market value is the estimated value of the property in the market, which is determined through an appraisal that considers comparable properties, recent sales data, and other factors.
A higher cap rate indicates a higher potential return relative to the property’s value.
Let’s say your property’s current market value is $1,000,000, and use the NOI of $80,000 from the previous example:
($80,000 / $1,000,000) x 100 = 8%
The 8% cap rate means the property is expected to generate an 8% return on the current market value annually.
A lower cap rate may suggest lower risk, but it could also mean lower potential returns.
Conversely, a higher cap rate may indicate higher risk with the potential for greater returns.
Investors use cap rates to compare different investment opportunities and to help evaluate the potential profitability.
Lenders and real estate investors use DSCR to evaluate a property’s ability to cover its debt obligations.
DSCR loans are used to purchase or refinance a rental property without using tax returns or personal income to qualify.
DSCR = NOI / Total Debt Service
Your total debt service refers to how much you need to pay to meet your debt obligations, including principal and interest payments on loans associated with the property.
Lenders typically have a minimum DSCR requirement that a property must meet to qualify for financing.
For example, a DSCR below 1.0 may indicate that the property is not generating sufficient income to cover its debt obligations.
If our NOI is $80,000 and our total annual debt service is $60,000, here is how we would calculate the DSCR:
$80,000 / $60,000 = 1.33
A DSCR of 1.33 indicates that the property’s income is 1.33 times the amount needed to cover its debt service.
A healthy ROI is crucial for DSCR loan approval.
GRM assesses the relationship between a property’s price and its potential rental income.
By calculating a property’s GRM, investors can determine how many years of gross rental income it would take to cover the cost of the property.
GRM = Property Price / Gross Rental Income
Property price reflects the current market value or purchase price of the property.
Gross rental income is the total income generated from renting out the property before deducting any operating expenses.
GRM helps investors compare different properties and identify those with a lower GRM.
If a property you’re evaluating is priced at $400,000 and the annual gross rental income is $65,000, here is how you would use the GRM formula:
$400,000 / $65,000 = 6.15
For many investors, a good GRM falls between 4 and 7.
CoC return helps investors evaluate the return on their actual cash investment in a property.
CoC Return = (NOI / Total Cash Invested) x 100
Total cash invested includes the amount of cash used to acquire and operate the property, which means:
- Down payment
- Closing costs
- Any additional cash invested in renovations or improvements
CoC return is a valuable risk assessment tool and helps investors compare different opportunities using a standardized measure of return.
A higher CoC return suggests a better return on investment and may be associated with a lower level of financial risk.
Let’s use the same NOI of $80,000 for this example, and say that the total cash invested (including the down payment, closing costs, and renovations) is $300,000.
($80,000 / $300,000) x 100 = 26.67%
Using this formula, investors can evaluate the potential profitability of a property and make the best decision based on their cash investment goals.
The 70% rule is a guideline commonly used for fix-and-flip properties, while the 1% rule is used for rental properties.
Let’s break them down.
The 70% rule suggests that an investor should not pay more than 70% of the after-repair value (ARV) of a property, minus the estimated repair costs.
You can use the following formula for this rule:
Maximum Purchase Price = 0.7 x ARV − Estimated Repair Costs
The 1% rule suggests that your monthly rent should be equal to or greater than 1% of the property’s purchase price.
You can use the following formula for this rule:
Minimum Monthly Rent = 0.01 x Purchase Price
The 70% rule and the 1% rule may not be suitable for every market or investment scenario.
Investors should consider local market conditions, property specifics, and their own financial goals before making investment decisions.
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