Evaluating Investment Property: Ratio Calculations
By Desert Dog on Jul 18, 2009 with Comments 0
No two investment properties are the same. Even if they sit right next to each other, have the same floor plan, and were built at the same time, there is something different about them. Rent rolls, maintenance, curb appeal, location, size, and a thousand other factors make comparing investment property a challenge. Like everything else in investing you need a system and this articles will give you some tools to help build your system.
As much as possible, you want to look at each property unemotionally; make it about the numbers and save the emotion for the after party. This can be difficult for beginners because there are so many subjective factors involved. A subjective factor is one that two investors may measure differently while an objective factor is the same no matter who looks at it. Curb appeal is subjective, while annual rent is objective. The first thing you should do is try to create boundaries for as many subjective factors as you can. How far away will you consider? I live in northeast Tucson so I really don’t want to work in Star Valley or Marana because it takes an hour to get there. What type of property do you prefer? How old? Does a one bath house turn you off? Do you like condos? Does fire damage scare you? You get the picture. In the beginning your focus should be pretty narrow until you gain experience with the market.
Once you identify your target market and find some interesting properties you need tools to evaluate them. Here are a few of the most common:
CAP Rate: (CAP=NOI/Price, where NOI is the net operating income). The Cap Rate is one of the most commonly used comparisons and is easy to calculate. In general a higher Cap Rate is better, and each investor will have a minimum rate that they will consider. To calculate the Cap Rate you first need the NOI. NOI is simply the Gross Annual Income of the property minus the Annual Operating Expenses (maintenance, taxes, insurance, management, etc). Mortgage payments are not included in the Annual Operating Expenses. Income and Expenses may be presented as Proforma or Actual. Proforma numbers are not documented and are the seller’s “best guess”. These can be very inaccurate at times! Use Actual numbers whenever possible.
example/ Sales price of a duplex is $109,000; annual rent is $12,000; annual expenses are $2,200 (tax $950, insurance $550, maintenance $700)
NOI=$12,000-$2,200= $9,800
CAP=$9,800/$109,000=8.99%
Alternately, you can use CAP Rate to determine your maximum purchase price. In the example above, if you have set a 10% CAP as your minimum, your purchase price is determined as follows
Price=NOI/CAP=$9,800/10%=$98,000
Gross Rent Multiplier: (GRM=Price/Rent) I have seen GRM calculated using both monthly and annual rents. I prefer to use annual rent, but it doesn’t matter if you are consistent. GRM is not widely used because it basically discounts maintenance and other expenses, but it is a quick and easy comparison. In general a lower GRM is better.
Using the above example:
GRM=$109,000/$12,000=9.1
Return on Investment: ROI is one of my favorite tools because it accounts for time, income, leverage, and expenses, and makes it easy to compare a real estate investment to other investments such as mutual funds. There are two common ways to calculate ROI; Cash on Cash, & Internal Rate of Return.
Cash on Cash: This is simply the ratio of your profit divided by the cash you invested. Leverage has a powerful effect on ROI.
Using our duplex above, we decide to buy at a 9% CAP ($109,000) & put 30% down ($32,700) and our closing cost is $3,000. Our monthly payment is $800 so we have a $200 positive cash flow each month. We plan to hold it for 12 months ($2,400 cash flow) and do $10,000 in repairs so we can increase our rent $100 per month (new annual income is $13,200) and then we will sell it at an 8% CAP with $3,000 in closing cost.
Net Investment=Down Payment + Costs=$32,700+($3,000+$10,000+$3,000+$2,200)=$50,900
Sales Price=New NOI/CAP=($13,200-$2,200)/8%=$137,500
Profit=(Sales Price+Cash Flow)-(Purchase Price+Costs)=($137,500+$2,400)-($109,000+$18,200)=$12,700
ROI=Profit/Net Investment=$12,700/$50,900=25%
If you paid all cash your Net Investment would be $127,200, so your ROI would drop significantly.
ROI=$12,700/$127,200=10%
Internal Rate of Return: IRR is much more complicated to calculate, but takes into account not just how much you invest and make, but when you invest it and when you take it out. Obviously, in our example it is better if your $10,000 in repairs is paid just before you sell rather than just after you buy since your money is tied up for a shorter amount of time. Cash on Cash calculations don’t show that, but the IRR calculation will. The IRR calculations are beyond the scope of this article, but IRR is considered superior to Cash on Cash for long term investments.
Obviously, this article just scratched the surface of investment analysis. However, these simple tools are extremely useful in comparing properties and setting your minimum investment requirements. When you feel your emotions getting the best of you, whip out your calculator and figure out your ratios. If the numbers don’t work then it is easier to walk away and if they do then you’ll be that much more confident going ahead with the deal.
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Filed Under: Investing • Real Estate
