The math behind real estate investment calculations is really pretty simple. But sometimes the acronyms and jargon can get in the way (NOI, ROI, IRR, GRM…it’s enough to make your head spin)
Don’t worry, we’ll cut through all the clutter and simplify all the numbers you’ll need to know. These are the calculations we use for our real estate investing clients whenever they are looking to buy, sell, or even figure out whether to keep holding a property.
1. Net Operating Income (NOI)
NOI = Operating Income – Operating Expenses
Net Operating Income (NOI) is the income left after accounting for your operating expenses and BEFORE debt service. Net operating income is one of the most important numbers you should know, because it’s also used in so many other calculations (such as cap rate, debt coverage ration, etc.)
NOI takes into account your gross income, vacancy loss, and operating expenses such as maintenance, repairs, taxes, insurance, and property management. Basically all expenses except for the principal and interest on your mortgage payment and capital expenses. NOI is what you have left at the end of the day to pay your lender – and therefore your lender finds this number extremely interesting.
Net Operating Income Example:
Let’s say you have a property that rents for $1,500 per month and we assume an 8% vacancy loss ($120). The property also has the following expenses:
- Repairs/maintenance – $150
- Property management (10%) – $150
- Property taxes – $200
- Insurance – $75
- Total expenses – $575
So your operating income is $1,380 ($1,500 – vacancy loss of $120), and your operating expenses are $695. That leaves you with an NOI of $805 ($1,380 – $575) per month, or $9,660 per year. Remember, this doesn’t account for your debt payments, but if you own the property free and clear, this is the amount that would go into your pocket.
2. Capitalization Rate (Cap Rate)
Cap Rate = NOI / Purchase Price
The Capitalization Rate (or “Cap Rate” for short) can be used as a simple calculation to compare similar properties. It essentially tells you the rate of return of a property if you bought it for cash. Since debt terms and amounts can often vary deal by deal, using the cap rate is a way to eliminate debt as a variable and compare the returns on a property as if you were paying all cash.
Cap rates are mostly used in the commercial real estate world, and cap rate data is collected for various product types (office, multifamily, industrial, etc.). Usually the riskier the asset, the higher the cap rate. So if you are comparing 2 multifamily properties, one that was built a few years ago in a hot area of town, and the other that was built 30 years ago in a Class B or C neighborhood, you would expect the latter property to have a higher cap rate.
To understand this, you can look at the equation (Cap Rate = NOI / Purchase Price). Assuming the 2 properties have the exact same NOI (net operating income), the lower the purchase price, the higher the cap rate.
In a vacuum, the cap rate is somewhat of a meaningless number. But when you know what cap rates other similar properties sold for, you can get an idea for what the market value of a property might be. Cap rates vary by asset type, asset class, geography, and many other variables. For example, a Class B multifamily in Cleveland, OH might trade at a 7% cap rate, whereas the same property in San Francisco might sell at a 4% cap rate.
Cap Rate Example:
Let’s compare the cap rates of 2 different properties in the same city. Suppose both of these properties had the same NOI of $1M per year. One property is brand new with the latest amenities in the best part of town. The other property is older and a little outdated, but in a decent neighborhood.
Let’s compare the cap rates of 2 different properties in the same city. Suppose both of these properties had the same NOI of $1M per year. One property is brand new with the latest amenities in the best part of town. The other property is older and a little outdated, but in a decent neighborhood.
If the brand new property with fancy amenities is priced at $25M, it would have a cap rate of $1M / $25M = 4%.
And if the older property had a market value of $16M, it would have a cap rate of 6.25%.
This example shows that a higher cap rate denotes a lower sales price for the same amount of income, based on desirability and risk of the property.
3. Rent to Cost Ratio
Rent to Cost Ratio = Monthly Rent / Total Property Cost
The Rent to Cost Ratio is another quick way to compare similar properties to each other. I use this all the time as a quick check to screen out properties I am considering buying, before I do a deeper dive into the financials.
This metrics gives you the monthly rent as a percentage of total property cost (purchase price plus any repairs needed to get it rent-ready). This is the ratio that is used for the popular 1% rule, which states that (in general) the rent to cost ratio should be at least 1% in order to cash flow as a rental property.
I have an entire article on the 1% rule and how to apply it. I think this is one of the most important concepts to learn as a new investor.
Rent to Cost Ratio Example:
Consider a property you are thinking of buying for $120,000 that needs $10,000 of work to get it ready to rent out at $1,500 per month. The rent to cost ratio would be:
Monthly Rent / Total Property Cost = $1,500 / ($120,000 + $10,000) = 1.15%
Based on the 1% rule, this is likely a good cash-flowing property (since the ratio is greater than 1%). You would want to do a deeper dive on the actual operating expenses and rehab costs needed, but the rent to cost ratio provides a quick and easy number to compare to other potential rental properties.
4. Gross Rental Multiplier (GRM)
GRM = Total Property Cost / Gross Annual Rent
The Gross Rent Multiplier (GRM) is another way of looking at the rent to cost ratio, and basically gives you the same information in a different format (an annualized number that is the inverse of rent to cost). I find the Rent to Cost Ratio to be more intuitive, but often times an advertisement might list the GRM and not the rent to cost ratio, so you want to be familiar with what it means.
The GRM is the total property cost (purchase price plus repairs needed) divided by the expected gross annual rents.
GRM Example:
Let’s use the same property as our example for Rent to Cost ratio ($120,000 purchase price, $10,000 in repairs to make rent-ready, and expected monthly rent of $1,500). The calculation would be:
GRM = Total Property Cost / Annual Rent = ($120,000 + $10,000) / ($1,500 * 12) = 7.2
This shows that the total property costs are 7.2X the annual rents. And since we used the same numbers as our previous example, a Rent to Cost Ratio of 1.15% is equivalent to a GRM of 7.2.
Note that if you are following the 1% rule as a quick screen, then that would be equivalent to a GRM of 8.33. With GRM, lower is better. So if you are using GRM to screen out properties that don’t meet the 1% rule, you’d want to only look at properties that had a GRM of 8.33 and below.
5. Debt Service Coverage Ratio (DSCR)
DSCR = Net Operating Income / Debt Service
The Debt Service Coverage Ratio (DSCR), or sometimes referred to as Debt Coverage Ratio (DCR) is a metric many lenders use to determine whether a property has enough income to cover the loan. DSCR is calculated by taking our friend, Net Operating Income (NOI) and dividing by the debt service (principal plus interest).
Most lenders want to see a DSCR of at least 1.2, which means that the property is generating enough to pay the debt plus an additional cushion of 20%. They also want to make sure your cash reserves (liquid net worth) can comfortably cover expenses for several months.
DSCR Example:
If you own a multifamily property that generates $100,000 in NOI monthly, and your payments to the lender are $80,000 per month, then your DSCR would be:
NOI / Debt Service = $100,000 / $80,000 = 1.25
This means that you are generating 25% more cash flow than it costs to pay the loan. This cushion helps protect the lender should things go south (higher vacancy, lower rents, etc.), and is also the amount that goes in your pocket as the owner after paying the lender.
6. Break-Even Ratio
Break-Even Ratio = (Operating Expenses + Debt Service) / Gross Income
The Break-Even Ratio is another way to look at how a property is performing in relation to the debt payments. It is similar to the DSCR, but answers a slightly different question – what percentage of the gross income do your total expenses account for? This metric can be used to easily see how much gross income can fall and still stay cash flow positive.
Break-Even Ratio Example:
Consider the same multifamily property in the DSCR example above. This time, we need the Operating Expenses (not to be confused with NOI) and Gross Income numbers. If Gross Income is $200,000 and Operating Expenses are $100,000, and the debt service remains the same at $80,000, you can calculate the Break-Even Ratio as:
(Operating Expenses + Debt Service) / Gross Income = ($100,000 + $80,000) / $200,000 = 0.9 or 90%
This says that the total expenses amount to 90% of the gross income. So if, for example, you had a 10% vacancy rate and your gross income dropped, you would be at the Break-Even Ratio (zero cash flow). This might be a marginal deal, because in a downturn, you could easily hit 10% vacancy or even higher, and not be able to make your debt payments.
7. Cash on Cash Return
Cash on Cash Return = Cash Flow Before Taxes / Cash Invested
The Cash on Cash Return is another metric I watch closely for my own rental properties. It gives you your annual cash return as a percentage of your total cash invested.
I like to make sure that any property I buy will give me at least a 10% cash on cash return after accounting for all expenses. This one is easiest to explain with an example.
Cash on Cash Return Example:
Suppose you are analyzing a new single family rental house to add to your portfolio. You can calculate your total cash flow (before taxes) by taking your NOI and subtracting debt service.
Let’s say the property is for sale for $150,000, and my expected NOI is $15,000 per year. I also want to get a loan for 70% of the purchase price (putting down $45,000). If the debt service is $10,000 per year, here is the calculation of cash on cash return:
Cash Flow Before Taxes / Cash Invested = (NOI – Debt Service) / Cash Invested = ($15,000 – $10,000) / $45,000 = 11.1%
That means that your actual cash return (what goes into your bank account) is 11.1% of your initial investment per year. Another way of looking at it, is it will take 9 years to make back 100% of your initial investment (100% / 11.1%).
While there are a lot of other benefits to owning real estate (such as appreciation, favorable tax treatment, and mortgage paydown), making sure you are cash flow positive is one of the most important things you can do to protect yourself in a downturn. That way, even if rents go down or vacancy goes up, you have some cushion to protect you and you won’t be taking cash out of your own pocket to pay the bills for your investment.
8. Price Per Square Foot (PSF)
Price Per Square Foot = (Sales Price or Rent Price) / Total Square Footage
Price Per Square Foot is another easy metric to compare similar properties, whether you are looking at the purchase price or rents they generate. It’s a simple calculation to understand – just take the sale price (or rent price) and divide by the square footage of the property.
If you know that in your area, a good rental generally sells for $100 per square foot, you can compare that to the asking price of a property to determine if it’s worth a further look.
Similarly, you can use this metric to get a rent price per square foot and compare it to other properties.
PSF Example:
Let’s say you are looking at 2 similar properties. One is a 1,000 square foot house that rents for $1,000 per month and is for sale for $100,000. The other is a 1,500 square foot house that rents for $1,300 per month and is for sale for $150,000.
Both have a sales price per square foot of $100 ($100,000 / 1,000 sf and $15,000 / 1,500 sf). But the smaller house has a rent price per square foot of $1 ($1,000 sf / $1,000), and the larger house has is $0.87/sf ($1,300 / 1,500 sf). All else being equal, the property that rents for more per square foot would provide more cash flow as a percentage of the amount you have invested.
Here at the Glenn Group we are experienced and ready to to assist you with all your real estate investing needs. Contact us today to learn more.