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.
Where do these sorts of comparisons fail? For example:
- ROI generally says nothing 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 go out of the window.
- ROI says nothing about future performance. If you purchase one property in a declining area, your rent (and therefore your return) is likely to fall. If the other property is in a rising market, rent will likely increase. In order for the comparison to be as "apples-to-apples" comparison as possible, 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.
- If one house is older or of poorer construction, it is likely to have higher maintenance than a newer property.
- A property in a colder and wetter climate will likely have higher maintenance than a property in a milder and dryer climate.
The point of this section is that you cannot blindly trust calculations. Common sense is critical when comparing properties.
I will be using the following property in the examples:
|Assoc. Fees (Mo)||0|
|Actual Annual Taxes (Ann)||1190|
|State Income Tax (%)||0%|
|Rehab Cost ($)||0%|
|Loan Rate (%)||4.50%|
|Debt Service (Mo)||880|
|Closing Cost Assumption|
|Closing Cost (%)||3%|
|Closing Cost Estimate ($)||6510|
|Property Management (%)||8%|
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
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.