Real estate investment provides value to the investor over time because of the future benefits in terms of cash flow, asset appreciation, and tax advantages. There are four characteristics of real estate that differentiate it from other investments. Those four characteristics that define real estate are immobility, longevity, indivisibility, and tax benefits. I know what you’re thinking – this seems like a lot to take in as a beginner. But, below are five real estate investment calculations that are easy to use when looking for an investment property!
Monthly Cash Flow = Gross Income – Operating Expenses – Financing Payments
For an investment to be attractive to you as an investor, the value of the cash flow each month needs to be positive. To determine cash flow, you will look at the gross income the property generates and subtract the operating expenses it costs to maintain the property. Operating expenses can include property insurance, property taxes, repair & maintenance, management, utilities, and vacancy and bad debt allowance. Then, you will deduct any financing costs such as the mortgage principal and interest to get your monthly cash flow. Of course, your cash flow will differ based on financing rates or if you do not require financing.
Total Gross Potential Income – Vacancy and Bad Debt Allowance
= Effective Gross Income
– Operating Expenses
= Net Operating Income
To calculate the net operating income, you will use the gross potential rental income from the property and subtract an amount for vacancy and bad debts allowance. For multi-unit investment properties, income can also come from parking, additional tenant services, or coin-operated laundry. The vacancy and bad debts allowance is expressed as a dollar or percentage amount. It forecasts any missed payments or any months where there may be no rental income. The property’s gross potential income minus vacancy and bad debt allowance will give you an effective gross income. Finally, the effective gross income minus any operating expenses will equal your net operating income for that property. Similarly to cash flow, the desired net operating income should be positive.
Capitalization Rate = Annual Net Operating Income / Purchase Price or Market Value
The capitalization rate for a property is another helpful calculation that is relatively straightforward. To find the capitalization rate, you will need to determine the property’s net operating income and divide that amount by the sale price or market value of the property. The capitalization rate is expressed as a percentage and it represents the return an investor would receive on an all-cash purchase. As a result, the capitalization rate calculates the rate of return before factoring in financing and taxes, which makes it easier to compare cap rates across similar properties.
ROI = Annual Net Operating Income / Down Payment or Cost
The return on investment is a profitability ratio that determines a property’s profitability based on its net operating income in a given year to the cost to acquire that asset. Unlike the capitalization rate, a property’s ROI will change depending on the investor’s financing. The ROI measures the profit of an investment as a percentage of the investment cost. A positive ROI indicates an attractive investment, while a negative ROI suggests looking for more profitable opportunities. You should compare the subject property’s ROI with other properties you’re interested in before making your investment decision to get a better understanding of the comparables within the market.
When you sell your property for a higher price than you purchased it for, a capital gain is realized. The capital gain is recorded at the time of the sale. When determining the amount of your capital gain, it’s essential to account for the costs and expenses to buy and sell your property. For instance, if after fees and expenses, you purchased a condo for $350,000 and then sold it five years later for $550,000, you would have a capital gain of $200,000. There are tax implications with capital gains, so it’s best to speak to an accountant.
The above calculations can be helpful for the beginning stages of your investment analysis. However, it’s also essential for investors to be familiar with the demand and supply factors influencing the specific real estate market where you are looking to invest.
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