According to Sean Tapenning, a real estate investor in Kansas City, Missouri, there are a lot of factors involved in the decision-making process that occurs before you invest in a new property. Obviously, the property itself, including its location and quality, come into play, as do certain financial considerations. It’s these financial details that we want to talk about today, and specifically the numbers and calculations you’ll need to run to determine if a property is worthy of your investment. Here are 5 of the numbers you’ll want to calculate before investing:
Rent/cost is an important tool for determining cash flow potential on a property - but only for like properties. In other words, this isn’t a calculation you’d want to use when comparing a dilapidated turn-of-the-century house to a newly built home in a gated community. However, if you’re eyeballing a property that’s surrounded by similar pieces of real estate, you need to whip out your calculator and divide the monthly rent by the total cost of the property. For instance, let’s say your rent is $800/month and your all-in cost for the home was $75,000. That comes to:
$800/75,000 = 0.01066, or 1.06%.
A good cash flowing property is going to be about 1.0%, but many investors shoot for 1.5%. Of course, your target number will probably be specific to your area, so keep that in mind as well.
Net Operating Income
Net operating income refers to all the income generated from a property, minus all the expenses to run it. NOI is an important figure that is used to calculate several other must-have pieces of information. To get your NOI, add up all your income (rent, application fees, etc.) and then subtract all your expenses (mortgage payment, insurance, property management fees, etc.). The result is your net operating income.
Your cap rate is the annual return you can expect to get from your property. Bear in mind, cap rate is used mostly for multi-unit or commercial properties. While it can be applied to single-family homes, the operating costs of these investments tend to be more erratic, which can skew the numbers. Still, it’s worth taking the 2 minutes to run this calculation. The formula divides the net operating income by the total purchase price. For example, let’s say your NOI is $9,000, and your total purchase price was $95,000, so:
$9,000/95,000 = 0.095, or 9.5
With these figures, your cap rate is 9.5. Cap rate varies widely from market to market, so be sure to evaluate what similar properties stand at when you’re running these figures.
Debt Service Ratio
If you need to secure financing for your investment, you’ll need to know this number. The bank will also be interested in this number, because it will help them decide whether or not they want to lend you money. Most financial institutions are looking for a ratio of 1.2 or higher; anything less than 1.0 means you’ll be losing money each month. To get the debt service ratio, divide your NOI by the annual debt service (total principal and interest to be paid over the year). Example:
$30,000/25,000 = 1.2
Cash on Cash
This is arguably the most critical calculation you’ll want to run, because this will shed some light on the kind of return you’re getting out of your investment. While it doesn’t factor in things like appreciation or tax benefits, it can give you a good idea about the profitability of your investment. To determine this figure, you’ll need to know what your cash flow is, as well as your total cash invested. If you’re unsure of your cash flow number, it is found by subtracting your debt service from your net operating income. So, let’s say you’re $40,000 into a property, and your cash flow stands at $10,000.
$10,000/40,000 = 0.25, or 25%
This means 25% was made on the property that year. This is a good figure to have, not only because it clues you into your return, but also because it can help you value a property and figure out financing options before purchase.
These are a just a few of the calculations you’ll want to know before you invest (and even after - it never hurts to run these numbers). There are several more that are also good to know, but these are the must-knows we tell all of our new investors to get familiar with.