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:

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

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.

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

Below are the calculations for the Austin property:

Below are the calculations for the Las Vegas property:

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.

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

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

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.

ROIa = 6%
ROIb = 5%

The difference in return would be:

ROIab Difference = ROIa - ROIb or 6% - 5% = 1%

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

ROIa = 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.