 Real Estate Math - Do You Know These Simple Formulas?
How much real estate math do you need to​ know if​ you are investing in​ real estate? There are computers and​ calculators for​ calculating interest rates or​ amortizing loans .​
What you need to​ know is​ a​ few simple formulas for​ determining if​ a​ property is​ a​ good investment or​ not.
The Real Estate Math You Don't Need
The gross rent multiplier is​ one formula you don't need .​
I​ bring it​ up because people are sometimes still using it, and​ there are better ways to​ estimate value .​
a​ gross rent multiplier is​ a​ crude way to​ put a​ value on a​ property .​
You decide that properties are worth 10 times annual rent or​ less, for​ example, and​ simply multiply the​ gross annual rent a​ building collects by ten to​ get your value.
There are obvious problems with this formula .​
You need to​ constantly change it​ to​ reflect interest rates, because a​ property might be profitable at​ 12 times rent when interest rates are low, but a​ money loser at​ eight times rent if​ the​ financing is​ expensive .​
Also, there are just plain different expenses for​ different properties, especially when some include utilities in​ the​ rent, for​ example .​
Gross rent doesn't say much about the​ factor that makes a​ property valuable: the​ net income.
Real Estate Math You Need
Rental properties are bought for​ the​ income they produce, so this is​ what your real estate valuation should be based on .​
That is​ why your real estate math education needs to​ start with the​ how to​ use a​ capitalization rate, or​ cap rate to​ determine value .​
a​ cap rate is​ the​ rate of​ return expected by investors in​ a​ given area, or​ the​ rate of​ return on a​ property at​ a​ given price .​
An example might make this clear .​
Take the​ gross income of​ a​ property and​ subtract all expenses, but not the​ loan payments .​
If the​ gross income is​ \$76,000 per year, and​ the​ expenses are \$32,000, you have net income before debt-service of​ \$44,000 .​
Now, to​ arrive at​ an​ estimate of​ value, you simply apply the​ capitalization rate to​ this figure.
If the​ normal capitalization rate is​ .10 (ask a​ real estate professional what is​ normal in​ your area), meaning investors expect a​ 10% return on the​ value of​ their investment, you would divide the​ net income of​ \$44,000 by .10 .​
You get \$440,000 - the​ estimated value of​ the​ building .​
If the​ common rate is​ .08, meaning investors in​ the​ area expect only an​ 8% return, the​ value would be \$550,000.
Simple Real Estate Math
Estimated value equals net income before debt-service divided by cap rate - this really is​ simple real estate math, but the​ tough part is​ getting accurate income figures .​
is​ the​ seller is​ showing you ALL the​ normal expenses, and​ not exaggerating income? if​ he stopped repairing things for​ a​ year, and​ is​ showing projected rents, instead of​ actual rents collected, the​ income figure could be \$15,000 too high .​
That would mean you would estimate the​ value at​ \$187,000 more (.08 cap rate).
Besides verifying the​ figures, smart investors sometimes separate out income from vending machines and​ laundry machines .​
Suppose these sources provide \$6,000 of​ the​ income .​
That would add \$75,000 to​ the​ appraised value (.08 cap rate) .​
Instead, you can do the​ appraisal without this income included, then add back the​ replacement cost of​ the​ machines (probably much less than \$75,000).
No real estate formula is​ perfect, and​ all are only as​ good as​ the​ figures you plug into them .​
Used carefully, though, real estate appraisal using capitalization rates is​ the​ most accurate method for​ estimating the​ value of​ income properties .​
For putting a​ value on a​ single family home, you need another approach .​
Yes this means more real estate math to​ learn, but we'll save that for​ another time.