Key Financials When Investing in Real Estate

By | March 29, 2012

Key Financials when looking at real estate:
Valuing a real estate investment is similar to valuing a business or a stock. For stocks, brokers use ratios such as P/E to see how expensive a stock is relative to the earnings the company produces. Much like this, rental property (especially commercial property), is valued solely on the rent it pulls every year times a market multiple. The higher the multiple, the more expensive it is based on the earnings it produces every year.


Rental property pulls in income every month and we can organize this into different categories:
-Rental Income
-Laundry Income
-Miscellaneous Income (application fees, late fees, ect)

Adding all of this nets the total Income that the property produces.

The second important thing to look at are the expenses to maintain the property. Here are typical expenses:
-Real Estate Taxes
-Management Fees
-Insurance
-Cleaning of halls and common rooms
-Trash disposal
-Pest control
-General Maintenance
-(We will leave off the mortgage till later, for now we will include operational expenses)

Subtracting Income and Expenses leads to Net Operating Income (NOI).
Income – Expenses = NOI

With NOI we subtract it to debt service.
NOI – Debt Service = Cash After Debt Service (CADS)

The goal of a rental property is to be a CADS machine, that makes a generous amount of CADS every month. This seems pretty simple, but often times, beginner investors go into an investment without first working the numbers if they make sense or not. It is important for the numbers to work on paper before you put out any offer. Also be a little pessimistic on your projections, accounting for vacancies and inability to collect rent.

Speaking of numbers, real estate investors routinely use Cap rate as an important financial measure of return over their investment.

Cap rate:
Cap rate is Net Operating Income / Purchase Price. It basically tells the investor the rate of return that the property is generating based on the income produced and the purchase price.

* Cap Rate = Net Income / purchase price

For instance, if a building is purchased for $1,000,000 sale price and it produces $100,000 in positive net cash flow (the amount left over after fixed costs and variable costs are subtracted from gross lease income) during one year, then:

* $100,000 / $1,000,000 = 0.10 = 10%

That asset’s capitalization rate is ten percent.

Capitalization rates are a measure of how fast an investment will pay for itself in net cash flows. In the example above, the purchased building will be fully capitalized (pay for itself in net income) after ten years.

Another important measure is Return on Income (ROI)

Return on Income (ROI) = CADS/Initial Investment

This ratio tells your return on your initial investment, accounting for only the cash you put into the deal. This is generally a better measure of your return than cap rate because it ignores any debt that you use when purchasing the property. You can compare this rate of return to other investments to determine which gives the highest returns, and therefore help make your decision in what to invest in. You wouldn’t put your money in a savings account that gives only 1% if you invest in rental property that gives 10% yearly returns.

Loan to Value (LTV) = Total mortgage/purchase price
This is just a ratio that tells you how much leverage you are using in terms of a percentage. Bankers often use the ratio when giving out commercial loans, and will require a down payment based upon the LTV that they are comfortable with. You may notice that with more leverage, the higher your mortgage payment is and thus decreasing CADS. Even if you are putting down a 20% downpayment, see if the deal works with 0 downpayment. That way you have a cushion of safety.

There are various rules that other real estate investors live by like the 50% rule or 2% rule. I will post this on another article. For now, I have just described a basic way to look at the financials of a real estate deal.

 

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Sincerely

Sam Lee

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