Basic Real Estate Formulas Every Investor Needs to Know

As an investor, having a clear understanding of how apply real estate formulas to analyze current and potential investments will help you achieve better returns. Managing real estate assets takes a specialized skill set that's different from that required by other investments. Here are some key real estate metrics to check when assessing a potential investment property:

Net Operating Income

Also known as EBIT (earnings before taxes and interest), NOI is simply the annual income generated by an income-producing property after taking into account all revenues collected from operations, and deducting all operation expenses. Net operating income measures the ability of a property to produce an income stream from operation. When evaluating prospective properties for purchase, investors will need to critically evaluate a property's NOI for every year of the projected hold period to arrive at an accurate market value. Unlike the cash flow before tax (CFBT) that is calculated on a typical real estate proforma, NOI is unique to the property, rather than the investor. This is because it excludes any financing or tax costs incurred by the investor.

Capitalization (CAP) Rate

Also known as the net rental yield or the CAP rate, it is used to calculate the total value of a property based on projected NOI (Net Operating Income) for a property. It is calculated by subtracting your estimated annual operating expenses from your annual rental income and dividing that number by the total cost of the property. The cap rate, therefore, takes into consideration of the operating expenses, annual vacancy allowance and credit losses of the rental property. A low cap rate is an indication of a lower-risk investment, and a higher cap rate represents a higher-risk opportunity. What constitutes a good cap rate depends on the market and the investor's appetite for risk, though most gravitate to cap rates in the 8-12% range. The disadvantages of the cap rate are that it only takes into account of the first year of operating data and doesn't take into account debt financing.

Gross Rent Multiplier

The gross rent multiplier (GRM) is another way to measure the value of an investment property. The Gross Rent Multiplier measures the ratio between a rental property's gross scheduled income (GSI), which is the property's total annual expected rent, and the value of the property. The GRM is quick and easy to calculate. It's not without its disadvantages, however, as it ignores occupancy levels and operating expenses. GRM is more reliable as a measurement for comparing properties. In areas where operating costs can be expected to be uniform across properties, GRM is especially useful for comparing and selecting investment properties for further analysis. 

Cash on Cash Return

CoC is the ratio between a property's pre-tax cash flow in the first year to the amount of initial capital investment required to make the acquisition such as mortgage down payment and closing costs. It is before tax calculation and doesn't take into consideration the buyer's tax bracket. As an investor, you should look at cash on cash return as it relates to cash flow before taxes during the first year of ownership. This metric takes into account financing on a property and will give you a good measure of the property's first-year financial performance. Investors should keep in mind that the cash-on-cash analysis is a quick calculation and not meant to be definitive.

Operating Expense Ratio

Operating expense ratio is a measure of what it costs to operate a real estate property in relation to the income the property brings. OER is an important indicator of the efficiency level of managing a property. It can often be helpful to calculate an operating expense ratio for each year in the holding period to spot significant trends in the total operating expenses, relative to potential rental income. The operating expense ratio is calculated by dividing a property's operating expense by its gross operating income (revenue after vacancy and credit loss). If a particular property exhibits a high OER, an investor should take it as a warning signal and look into the matter for why the OER is high.

It is critical for every investor to consider each of these metrics in their real estate analysis. Your success or failure as a real estate investor happens before you buy.