Financial Formulas for Real Estate Investors

 

Your first step into Real Estate can be intimidating. NOI, GSI, GOI, DSCR, Cap rate GRM, etc. Many times, even after you find out what they mean, you still don't know what they really mean, how to calculate them, which ones are really important, and how they will help you. My experience is with apartment buildings and buy & hold strategies, so I most likely will miss some of the nitty gritty that may apply to other types of investing. We'll Start from the top.

 

GSI (Gross Scheduled Income):

Total Monthly Rents X # Units X 12 Months = GSI

 

Theoretical Total Rents Possible (Yearly)

This is simply the theoretical Maximum income that a property will produce based on the current rents. This is the starting point for the calculations that follow.

 

GOI (Gross Operating Income):

GSI X Occupancy factor = GOI  Total rents actually collected (Yearly)

 

Occupancy factor

The inverse of vacancy factor. In other words if you have a 90% occupancy factor, you've got a 10% vacancy factor.

 

NOI (Net Operating Income):

GOI - Expenses = NOI   Net Income (Income AFTER expenses, but Before Debt Service)

NOTE: DO NOT include your debt service (i.e. mortgage payment) in the expenses in the equation above. DO, however, include Bad debt, vacancy, utilities, turnover, etc. Essentially it is the net income that you would bring in yearly if you owned the property free and clear.

NOI is perhaps the most useful number of the bunch. After all, it really doesn't matter how much you bring in, what matters is how much you keep. This number will come up when talking to sellers, buyers, bankers, mortgage brokers, etc.

 

Expense Factor:

1 - (NOI / GSI) = Expense Factor   Percentage of GSI that goes to expenses.

This is essentially the difference between the GSI and the NOI represented as a fraction. It is calculated by taking the inverse of NOI/GSI, as shown above. VERY FEW people will ask to see this number. Use it if you like it, not because you need to. I use it because I know that in my area, the way I manage properties, the expenses should be around 35%. If I get a seller who tells me his numbers and this comes in at 15% (which happens all the time) I have a good indication that he's not showing me the whole picture (inflated income, deflated expenses, or both). You'll learn what it is for your area and your style, but 25-50% would be a normal range. Keep in mind, terribly managed property can throw this out. If it's 25% occupied, they're paying 75% of the utilities, and a property management company $40 an hour to change light bulbs, then you'll get an expense factor of 70% or so. Just make sure you understand irregularities.

 

Cash Flow (CF or PCF)

NOI - Debt Service = Cash Flow

Easy enough to calculate, although remember: Garbage in, Garbage out. You need good data to produce good data. You should have a cash flow goal of some sort. Mine, for example, is $50-$100 per unit per month. If it's not going to make AT LEAST $50 bucks per unit per month, it's not worth my time. If you're doing homes, you may want to say $150 or so. In any case, know what you're willing to buy and what you are not before you get bargaining with someone. Know at what point you'll walk away. Also note that a slight alteration in your interest rate and amortization will have a tremendous impact on your cash flow. DO NOT GUESS WHEN IT COMES TO THESE TWO THINGS. I can't stress that enough.

 

Cap: (Capitalization Rate)

NOI / Price = Cap

Ahhhh, perhaps the most elusive number of all. Simply stated, it's the ROI (Return on investment...see below) that you would receive if you paid cash for a property. The NOI would go straight to your back pocket. This is mostly used to compare value (or income producing power) of dissimilar properties, starting at 3 units and going up from there. As it is difficult to find comps for 20 unit complexes that have sold recently and are in similar areas, shapes, conditions, etc, Cap is one of the methods that is used to evaluate, price, and compare these properties. You can also use this to evaluate a carwash, warehouse, mobile home park, etc. Personally, It's my favorite number to use. Generally, properties that are easy to buy (1-4 units) will have a lower cap (say 7%) because there are more buyers. 5+ units, and cap rates will rise to 9-10%. You WILL see properties that have a cap of 12-20%. Beware! These are often high risk properties for one reason or another. Location, crime, vacancy, deferred maintenance. Notice I said "Beware" and not "run away". Often these are the diamonds in the rough that no one else wants to touch. There is a great deal of money to be made (or lost) in these types of properties. Made if you know what you're getting into, lost if you don't. Also note that Cap does NOT take into consideration your loan. Something that has a great Cap (say 12%) may not cash flow if you get a 10% interest loan with a 15 year amortization.

 

Gross Rents Multiplier (GRM)

Price / Rent = GRM

This is a "back of the envelope" technique to figure out how good (or bad) a deal is. No one will ever ask you for this number. Use it if you like it, but don't stress over it. I personally use it very little. Most people will divide the price into the monthly rents. I personally use the yearly rents. The ratio is the same either way. Again, run this with 50 properties in your area, and you'll get a good feel for an average. Going over 130 is suicide (off yearly rents). 110-120 tends to be FMV (Fair Market Value). Under 100 will probably cash flow. Under 80 and you've got a deal. If you use the monthly rents, divide those numbers by 12 and it will give you the same ratios using the monthly, rather than the yearly, rents.

 

Return On Investment (ROI):

Yearly Cash Flow/Down Payment = ROI

Annual return that you get from Out of pocket cash that goes into a deal.

When you see a bank offer a 2% Money Market certificate, that's a 2% ROI. Take $100 bucks, leave it there for a year, at the end of 12 months you'll have $102. (Note: This is not the best way to retire!). Take that same $100, use it for a down payment on a house that gives you $100 per month back, and that's a 1200% ROI (MUCH better way to retire). If you're doing deals with low down payments and much higher yields, this number is useless (e.g. 28,439% ROI). You can brag to your friends about it, but it's not useful. I would encourage you to include any costs that you have to pay with your own money, up front, when calculating this (Down payment, inspection, appraisal, attorney fees, etc). Those things truly are necessary to do the deal. If you find that after putting down a sizeable down payment and after all your blood, sweat and tears, you're only generating 2% return, then the stock market, or a new investing technique may be for you.

 

Debt Service Coverage Ratio (aka Debt Coverage Ratio. DCR or DSCR)

NOI/Yearly Debt Service = DSCR

Ability to pay mortgage from the properties income

This reflects the ability of the income produced by the property to pay the mortgage. Lenders, Mortgage brokers, and Partners are the people that will be interested in this number. 1.20+ is standard, with 1.50 being safe. If you have a ratio of 1.0 you're bringing in (net) the same amount that you're paying to the bank on your mortgage. Anything below 1.0 is negative cash flow. Anything under 1.20 is marginal enough that you should be nervous and will have a hard time getting financed. Again, you may find exceptions to this, which is fine, as long as you can explain them. For example, a bank owned, vacant 4plex. Obviously it will generate no income when you buy it. That doesn't mean that it isn't a great deal and can't be financed, it only means you'll have to explain a few things to the lender.

 

Internal Rate of Return (IRR)

Use a spreadsheet, financial calculator, or property analysis software program to calculate this. (It's kind of a gnarly equation) Figure this one out AFTER you've got every one of the above terms and definitions down pat. You don't need to know this to make money. Strictly speaking, it is the Net Present Value of a series of future cash flows. In other words it's the Rate of Return that would make the present value of future cash flows plus the final market value of an investment or business opportunity equal the current market price of the investment or opportunity. It's also called dollar-weighted rate of return or Total Return.

In short it's ROI on steroids, considering the time value of money. It not only takes into consideration the income generated from cash flow, but also from equity buildup, appreciation, and tax shelter. It can be speculated, but can only be truly accurate retroactively after the property is sold. With an accurate IRR you can compare investing in real estate to investing in any other market (stocks, bonds, etc). I do not use this for 2 reasons. First of all, it tends to be misleading. Even when calculated accurately, you could have a property that has a 8% return for an IRR, yet a negative cash flow for the holding period. THIS, my friend, is why realtors will want to show you the IRR. It seems to sweetens the deal. 8% is fine for some people, but I want and need positive cash flow. Secondly, If it cash flows now and is not turning into a ghost town, then it will cash flow in the future, appreciate, and give me tax shelter. I don't need a number to tell me that. I would, however, look at it when you're doing $10 Million dollar deals. Until then, you're fine without it.

 

A few others to consider:

 

You may want to explore Blended (Interest) Rates if you're using 2 or more loans to find out the average interest rate if they were combined into one loan.

 

Break even point: found by dropping the rents, the occupancy rate, or both to discover how low they can go before it becomes an alligator.

 

You may also consider evaluating properties based on Price per unit or price per sq. foot.

 

Don't forget to allocate funds for Capital Improvements. Even when you're paying all of your expenses and mortgages, things will come up. Roofs, driveways, and carpets, furnaces, water heaters, etc need to be replaced. Things come up. Vandalism, meth labs, mold, etc. Things happen. Budget a portion of your income to be set aside in an interest bearing account for a rainy day.

 

Finally, use what works for you. Be pessimistically realistic.