Real Estate Investing Math
The purpose of return calculations is primarily to compare properties, not necessarily to show 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.
Having said that, these sorts of comparisons have limitations because ROIs do not provide any information about:
- Time-to-rent in the case of single family properties. And, if it takes 3 months to rent one and 2 weeks to rent the other, the return calculations are impacted.
- Future performance: If you purchase one property in a declining area, your rent (and therefore your return) is likely to fall. For the comparison to be "apples-to-apples", the two properties need to be in close proximity, in the same economic and demographic environment or at least the two locations need to have a very similar economic outlook.
- Construction factors: If one house is older or of poorer construction, it is likely to have higher maintenance than a newer property.
- Climatic factors: A property in a colder and wetter climate will likely have higher maintenance than a property in a milder and dryer climate.
The point here is that you cannot blindly trust calculations. Common sense is critical when comparing properties.
I will be calculating return using the following property in the following examples:
|Assoc. Fees (Mo)||0|
|Actual Annual Taxes (Ann)||1190|
|State Income Tax (%)||0|
|Rehab Cost ($)||0%|
|Loan Rate (%)||4.50%|
|Debt Service (Mo)||880|
|Closing Cost (%)||3%|
|Closing Cost Estimate ($)||6510|
|Property Management (%)||8%|
Calculating Cash Flow
Cash flow is (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
ROI is ((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 is not hard to calculate real estate investment returns. Remember that return calculations only predict what return is likely to be today. Return calculations tell you nothing about the future. The image below shows two properties with same return in two different markets.
One property is in a static or declining market (red line). The second property is in an appreciating market (green line). They both have the same return today but 10 years from now their return is very different. Never select a property only based on current return, you are going to hold the property for a long time so what happens in the future is actually more important than what is happening today.