Real Estate Math

There are a lot of people selling software packages for calculating returns, cash flow, comps and other needed values, making real estate investment analysis sound complicated and daunting. In this newsletter I will explain how to do the basic calculations. Before I get into the calculations, I want to talk about the purpose and limitations of calculated values.

Purpose of Return Calculations

The purpose of return calculations is primarily to compare properties. It does not necessarily equal the return you will actually experience because of taxes and other factors. However, assuming all significant recurring costs are included, if one property has a calculated return of 4% and another has a 5% return, then the property with the 5% return will most likely generate an actual higher return.

Limitations

Where do these sorts of comparisons fail? For example:

The point of this section is that you cannot blindly trust calculations. Common sense is critical when comparing properties.

Example Property

I will be using the following property in the examples:

Acquisition Assumptions
Purchase Price 217000
Assoc. Fees (Mo) 0
Actual Annual Taxes (Ann) 1190
Insurance (Ann) 450
State Income Tax (%) 0%
Rehab Cost ($) 0%
Financing Assumptions
Loan Rate (%) 4.50%
Term (Yr.) 30
Down (%) 20%
Down ($) 43400
Debt Service (Mo) 880
Closing Cost Assumption
Closing Cost (%) 3%
Closing Cost Estimate ($) 6510
>Management Assumptions
Property Management (%) 8%
Income Assumptions
Rent (Mo) 1300

Calculating Cash Flow

I define cash flow as: (Income - Recurring Costs) - State Income Tax. Below is the formula we use:

Cash Flow = (Income - DebtService - ManagementFee - Insurance - RETax - PeriodicFees) x (1 - StateTax)

Below is the cash flow calculation for the example property. Note that I am using monthly income/cost numbers. You could use annual numbers and divide by 12 if you want monthly cash flow:

Ann. Cash Flow = (1300 x 12 - 880 x 12 - 8% x 12 x 1300 - 450 - 1190 - 0) x (1 - 0%)

Ann. Cash Flow = 2152 or Mo Cash Flow = 179/Mo

Calculating Return

I define ROI as: ((Income - Recurring Costs)- State Income Tax)/(Acquisition Costs). Below is the formula we use:

ROI = ((Income - DebtService - ManagementFee - Insurance - RETax - PeriodicFees) x (1 - StateTax)) / ( DownPayment + ClosingCosts +RehabCost)

Plugging in numbers for the example property:

ROI = ((1300 x 12 - 880 x 12 - 8% x 12 x 1300 - 450 - 1190 - 0) x (1 - 0%)) / ( 43400 + 6510 + 0)

ROI = 4.3%

I hope the above helps. It really is not rocket science to calculate real estate investment returns.