# Estimating Return

There are many ways to calculate return. In this article I will show the formulas we use and how they compare to some others.

Before I get into formulas, know that return estimates are only effective for comparing properties. They do not show your actual return because they do not include taxes. Taxes have a huge impact. If you wish to estimate your actual return, model your financial/tax situation and then add the investment property. The difference is a good indicator of your actual return. That said, a property with a higher calculated return will provide a higher actual return than one with a lower return.

Below are the formulas we use for **comparing properties**. Note that we do not include factors for rehab, vacancy or maintenance. Rehab, vacancy, and maintenance are property specific. Even if there were such constants, the difference in return between properties would not change. I will show this later.

ROI = (Income - Debt Service - Management Fee - Insurance - RETax - Periodic Fees) x (1 - StateIncome Tax) / ( Down Payment + Closing Costs)

Cash Flow = (Income - Debt Service - Management Fee - Insurance - RETax - Periodic Fees) x (1 - State IncomeTax)

Below is an explanation of the variables:

- Income: The monthly rent x 12.
- Debt Service: 12 x the monthly mortgage payment (principal and interest).
- Management Fee: Management fee percentage x annual rent.
- Insurance: Estimated annual landlord insurance.
- RETax: Annual property tax.
- Periodic Fees: The sum of all periodic fees.
- State Tax: Nevada has no state income tax so this is always zero. If you are comparing a property in Nevada to one in another state, use the appropriate tax rate for that state.
- Down Payment: For a financed purchase we use the down percent * the purchase price. For cash purchases, it is the total purchase price.
- Closing Costs: We use 3% x purchase price for financed properties and $2000 for cash purchases.

So you can see how it all fits together below are example calculations on the following property:

- Purchase price: $150,000
- Rent: $1,000/Mo. or $12,000/Yr.
- Financing: 30 year, fixed rate of 4.5%, with 20% down. The payment would be approximately $608/Mo. or 7,296/Yr.
- Management fee is 8% x annual rent or $12,000 x 8% = $960
- Landlord insurance: $450/year
- Property tax rate: 0.77% or $150,000 x 0.77% = $1,155/Yr.
- HOA fee is $20/Mo. or $240/Yr.
- State income tax rate: 0%
- Down payment: 20% x purchase price or: $150,000 x 20% = $30,000.
- Closing costs: 3% of purchase price: $150,000 x 3% = $4,500

If we plug the above values into the formulas:

ROI = (12000 - 7296 - 960 - 450 - 1155 - 240) x (1 - 0) / (30000 + 4500) = 5.5%

Cash Flow = (12000 - 7296 - 960 - 450 - 1155 - 240) x (1 - 0) = 1899/Yr

## Comparing Properties in Different Locations

I will next use the formulas to compare two (actual) properties, one in Austin and one in Las Vegas.

Location | Austin | Las Vegas |
---|---|---|

MLS/Address | 1551927 - 204 Joshua Tree Cir | 1851544 - 7354 Divine Ridge St |

Asking Price | $252,500 | $255,000 |

Estimated Rent | $1,700 | $1,490 |

SqFt | 2068 | 2033 |

Beds | 4 | 3 |

Baths | 3 | 3 |

Stories | 2 | 2 |

Monthly Fees | $41 | $41 * |

Ann Property Tax | $6,022 | $1,511 |

Insurance | $1,625 | $450 |

MLS Data Sheet | Link | Link |

Note, I used the same association fee for both properties to keep things "apples to apples". Below are the assumptions I will use for both properties.

- 20% down
- 4.5% rate
- 30 year term
- 3% closing cost
- 8% property management
- 0% state income tax. Neither Texas or Nevada have a personal state income tax.

Below are formulas I showed earlier for ROI and cash flow:

- ROI = (Income - DebtService - ManagementFee - Insurance - RETax - PeriodicFees) x (1 - StateIncomeTax) / ( DownPayment + ClosingCosts)
- Cash Flow = (Income - DebtService - ManagementFee - Insurance - RETax - PeriodicFees) x (1 - StateIncomeTax)

Below are the calculations for the Austin property:

- ROI = (1700 * 12 - 1024 * 12 - 1700 * 12 * 8% - 1625 - 6022 - 41 * 12) / (3% * 252500 + 20% * 252500) = -2.9%
- Cash Flow = (1700 * 12 - 1024 * 12 - 1700 * 12 * 8% - 1625 - 6022 - 41 * 12) = -1659/Yr. or -139/Mo.

Below are the calculations for the Las Vegas property:

- ROI = (1490 * 12 - 1033 * 12 - 1490 * 12 * 8% - 450 - 1511 - 41 * 12) / (3% * 255000 + 20% * 255000) = 2.7%
- Cash Flow = (1490 * 12 - 1033 * 12 - 1490 * 12 * 8% - 450 - 1511 - 41 * 12) = 1600/Yr. or $133/Mo.

The following is a table comparing the two properties:

Assumptions | Austin | Las Vegas |
---|---|---|

Purchase Price | 252500 | 255000 |

Rent (Mo) | 1700 | 1490 |

Fees (Mo) | 41 | 41 |

Insurance (Yr.) | 1625 | 450 |

Property Tax (Actual) | 6022 | 1511 |

Management (%) | 0.08 | 0.08 |

Closing Cost (%) | 0.03 | 0.03 |

Loan Rate (%) | 0.045 | 0.045 |

Loan Term (Yrs.) | 30 | 30 |

Down (%) | 0.2 | 0.2 |

Acquisition Cost | ||

Down Payment | 50500 | 51000 |

Closing Cost | 7575 | 7650 |

Total | 58075 | 58650 |

Recurring Expenses (Mo) | ||

Debt Service | -1024 | -1034 |

Insurance | -135 | -38 |

Property Tax | -502 | -126 |

Fees | -41 | -41 |

Total | -1702 | -1239 |

Income (Mo) | ||

Rent | 1700 | 1490 |

Management | -136 | -119 |

Net Rent | 1564 | 1371 |

Return | ||

Cash Flow (Mo) | -138 | 132 |

ROI | -2.9% | 2.7% |

Below are some popular formulas I found on various investment sites.

Rent/price ratio - higher is better. As you can see, the result is invalid.

- Austin: 1700 × 12 / 252500 = 8.1%
- Las Vegas: 1490 x 12 / 255000 = 7.0%

Calculating returns without property taxes and insurance. The result is invalid.

- Austin: ROI = (1700 * 12 - 1024 * 12 - 1700 * 12 * 8% - 41 * 12) / (3% * 252500 + 20% * 252500) = 10.3%
- Las Vegas: ROI = (1490 * 12 - 1033 * 12 - 1490 * 12 * 8% - 41 * 12) / (3% * 255000 + 20% * 255000) = 6.1%

Adding principal pay down using the above formula. The result is invalid.

- Austin: ROI = (1700 * 12 - 1024 * 12 - 1700 * 12 * 8% - 41 * 12 + 3258) / (3% * 252500 + 20% * 252500) = 15.9%
- Las Vegas: ROI = (1490 * 12 - 1033 * 12 - 1490 * 12 * 8% - 41 * 12 + 3291) / (3% * 255000 + 20% * 255000) = 11.7%

Now let's look at the impact of including a constant for vacancy and maintenance. Suppose I have two properties, property A and property B with the following returns.

ROI_{a} = 6%

ROI_{b} = 5%

The difference in return would be:

ROI_{ab} Difference = ROI_{a} - ROI_{b} or 6% - 5% = 1%

If the constant for maintenance plus vacancy is 1%, the returns would now be as follows:

ROI_{a} = 6% - 1% = 5% ROI
_{b} = 5% - 1% = 4%

The difference in return remains the same, 1%. So including such provisions in comparison calculations does not change the difference in return.

## Summary

You must include all significant recurring costs when you are comparing properties. Simplistic calculations like rent to price ratio frequently produce invalid results. Also, remember that ROI, cash flow, and other such metrics are only snapshots in time. They do not indicate how a property is likely to perform in the future.