Profitability of an Investment

To be successful in real estate, it is important to understand the real estate numbers behind an investment property. This includes knowledge of real estate investment formulas and ratios. These may look complex at first but are relatively easier to understand and master. The good news is that there are investment calculators that will do the grunt work and give all projections for sound decision making. Calculations apart you still need to understand what each terminology means to know the value and returns of an investment.

Gross Scheduled Income (GSI)

Gross Scheduled Income is the rental income collected in a year assuming the property is 100% tenanted and all rents are collected. Rents of vacant units are included at their reasonable market rent for the purpose of calculation.

Gross Scheduled Income = Rental Income (actual) + Vacant Units (at market rent)

Gross Operating Income (GOI)

Gross Operating Income (GOI) is calculated after subtracting from the GSI income from vacancies and adding income derived from other sources such as coin-operated laundry facilities. GOI can be considered as actual income the investor collects from the rental property.

Gross Operating Income = Gross Scheduled Income – Vacancy and Credit Loss + Other Income

Operating Expenses (OPEX)

OPEX function on annual costs associated with keeping a property in service and fully operational. These include body corporate fees, property taxes, insurance, routine maintenance and payment of utilities. Payments made for mortgages, capital expenditures or income taxes are not included in OPEX.

Net Operating Income (NOI)

Net Operating Income is arrived after subtracting OPEX from the Gross Operating Income.

Net Operating Income = Gross Operating Income – Operating Expenses

NOI is an important indicator to a property investor to arrive at a price he is willing to pay for an income stream.  It determines the property’s market value.

Cash flow before Tax (CFBT)

Cash flow before Tax is the income a property generates in a given year before tax after deducting all expenses.

Cash flow before Tax = Net Operating Income – Debt Service

Cap Rate

Cap Rate or Capitalization Rate is the ratio between the net operating income and a property’s market value. It is a very popular term used to calculate a property’s estimate of market value.

Cap Rate = Net Operating Income ÷ Market Value

Or,

Market Value = Net Operating Income ÷ Cap rate

Note of Caution – You can arrive at totally different and wrong market value by applying wrong Cap Rate. Great effort should be taken to find out the correct Cap Rate for a particular type of property in a given area.

Cash on Cash Return (CoC)

Cash-on-cash return is used in real estate to calculate the cash income earned vis-a-vis cash invested in a property.

Cash on Cash Return = Cash flow Before Taxes ÷ Initial Capital Investment

Most investors usually look at cash-on-cash as it relates to cash flow before taxes during the first year of ownership.

Calculating the Cash-On-Cash Return

For example, a real estate investor invests in an industrial warehouse that does not produce monthly income. Let us say the total purchase price of the property is $1 million.  The investor puts 10% ($100,000) down and borrows $900,000 from the bank. In the first year, the investor pays maintenance and insurance costs of $10,000 out of pocket.

In the first year, the investor pays $25,000 in loan payments which includes $5,000 is principal repayment and $20,000 towards interest. This will imply that the investor’s total out of pocket cash outflow during the first year is $135,000

After one year, the investor sells the property for $1.1 million. After repaying debt owed to the bank of $895,000, he is left with a cash inflow of $205,000.

In this case, the investor’s cash-on-cash return is: ($205,000 – $135,000) / $135,000 = 51.9%. This is a very healthy return in one year. In case the property was rented, CoC would have been higher.

Cash-on-Cash return can also be used to forecast future cash earnings from an investment. It is an estimate of what an investor may expect to receive over the life of the investment.

Operating Expense Ratio (OER)

Operating Expense Ratio is the ratio between a real estate investment’s total operating expenses dollar amount to its gross operating income. It is expressed as a percentage.

Operating Expense Ratio = Operating Expenses ÷ Gross Operating Income

Higher OER is matter concern when a commercial property is vacant. The owner will need to pay OPEX out of pocket that can considerably bring down rate of return from a property.

Debt Coverage Ratio (DCR)

Debt Coverage Ratio (DCR) is the ratio between annual net operating income and debt service (includes both principal and interest loan payments.)

Debt Coverage Ratio = Net Operating Income ÷ Debt Service

What DCR ratios indicate?

• Less than 1.0 – Net Operating Income will not cover debt servicing requirement.
• Exactly 1.0 – Net Operating Income will just about cover the debt requirement.
• Greater than 1.0 – There is adequate Net Operating Income to cover the debt

Break-Even Ratio (BER)

Lenders use BER to calculate ratio between the cash out flow to cash inflow from a property to determine how vulnerable the investment is to defaulting on its debt obligations. BER is expressed as percent.

Break-Even Ratio = (Operating Expense + Debt Service) ÷ Gross Operating Income

BER analysis:

• Less than 100% – expenses are less than income. Investment is in healthy shape.
• Greater than 100% – expenses are more than income being generated. This is matter of concern to lenders as the investor may default in case they do not have alternate sources of cash flow.

Loan to Value (LTV) or Loan to Value Ratio (LVR)

Loan to Value is the ratio between the loan amount to property’s selling price or appraised value (whichever is lesser.) LVR is the lending criteria that financial instructions apply when approving a loan. It depends on their policy and type of property against which the loan is being given. LTV determines the leverage that an investor can use when purchasing an investment property. A higher leverage can result in higher returns but can also be risky.

Loan to Value = Loan Amount ÷ Lesser of Selling Price or Appraised Value

Annual Depreciation Allowance

Annual depreciation allowance is the annual tax deductions allowed on an investment property. It varies depending upon the tax code of a country.

Depreciable Basis = Property Value x Percent Allotted to Improvements

Next step:

Annual Depreciation Allowance = Depreciable Basis ÷ Useful Life

Taxable Income

Taxable income is the amount which the owner has to pay based on taxable income derived from the property which is calculated as per the formula below:

Taxable Income = Net Operating Income – Mortgage Interest – Depreciation – Capital Additions – Closing Costs + plus Interest earned in bank or escrow

To arrive at the tax payable by an investor, Taxable Income is multiplied by marginal tax rate.

Tax Liability = Taxable Income x Marginal Tax Rate

Cash flow after Tax (CFAT)

Cash flow after Tax. as the name suggests, is the cash flow accruing from a property after paying tax.

Cash flow after Tax = Cash flow before Tax – Tax Liability

This is the money that an investor can spend to either support their lifestyle or to make future purchases.

Time Value of Money

The value of money is dependent upon the time we need it for. Time of receipt of money, at times, may be more valuable than the amount we receive. This is an important consideration in real estate investing that may at times be hard to liquidate. It is the reason why some people sell their assets below value.

Present Value (PV)

Present Value (PV)shows what future cash flow is worth in terms of present value of dollars. We calculate PV by “discounting” future cash flows by applying “discount rate.”

Future Value (FV)

Future Value (FV) – as the name suggests – is the cash flow in the future at a specified time. FV is calculated by applying a given “compound rate” forward in time.

Net Present Value (NPV)

Net Present Value (NPV) tells an investor whether the investment is achieving a target yield based on initial investment: it is the difference between the PV of future cash flows after applying a particular discount rate minus the initial cash invested in purchasing those cash flows.

Net Present Value = Present Value of all Future Cash flows – Initial Cash Investment

NPV Analysis:

• Negative – means the required return on an investment is not met
• Zero – the required return is met as per plan
• Positive – achieved higher than the required return

Internal Rate of Return (IRR)

The internal rate of return (IRR) for an investment property is the percentage rate earned on each dollar invested for each specified period of investment. IRR is also another term people use for interest or yield.

The internal rate of return (IRR) for an investment property is an estimate of the return it generates for each dollar invested during the time frame in which you own it. In simpler terms: IRR is the percentage of interest you earn on each dollar you have invested in a property over the duration of period you hold the property.

For instance, you purchase a retail shop to for a period of 10 years. The compounded interest earned over the 10-year period would represent the IRR.

IRR is a great way to estimate a real estate investment’s profitability over a period of time. Unlike Cap Rate, IRR looks beyond the property’s net operating income and its purchase price. It gives a clearer picture of expected returns on an investment from start to finish. This is a great tool to analyze profitability of an investment if you are planning to hold it for a long duration.

Formulas for calculating IRR are complex and it is advisable to use an investment calculator or software.

Escrow and Real Estate

Escrow accounts are funds held by a reliable third party to enable the buyer to preform due diligence on a property, assuring the seller they have the capacity to close deal at the end of the stated period. Once the conditions on the sale, such as building inspection or getting satisfactory valuation report are fulfilled, the escrow account holder will release and transfer the payment to the seller. The title of the property is transferred to the buyer.

How to Calculate Rate of Return (ROI) for Real Estate Investments

There are various methods of calculating Return on Investment or ROI of an investment property. In the succeeding paragraphs, we will discuss some of the important ones.

The most common method of calculating Return on investment (ROI) is by using the simple formula:

The above equation may look easy to calculate but care needs to be taken to get accurate figures on variables such as repair and maintenance costs, interest on loans, rates, insurances, etc. ROI will be higher if your initial purchase price for the investment is low. Apart from the initial purchase cost, finance cost is another important factor in determining ROI. You must shop for the cheapest loan. Even a small amount of variation in interest rate can have a major implication on ROI.

The Cost Method for Calculating ROI

In the cost method, ROI is calculated by dividing equity in the property by all costs incurred (these include the initial purchase price plus cost of improvements.)

As an example, let us assume that we buy an investment property for $100,000. Let us say that it costs additional $50,000 to carry out repairs and make improvements to the property. On completion of the upgrade, the property valuation comes to $200,000. The investors’ equity position in this example will be $50,000. This is arrived at by subtracting the initial purchase cost of $100,000 plus $50,000 repair cost from the revalued price of $200,000.

200,000 – (100,000 + 50,000) = 50,000

ROI from the cost method is arrived at by dividing the equity by all the costs related to the purchase, the upgrade and the repairs in the property.

ROI, in this example, works out to 33% ($50,000 divided by $150,000 multiplied by 100).

The Out of Pocket Method

The Out of Pocket method is very similar to Cost Method but in calculating ROI, only out of pocket cash is taken into account.

Using the same numbers in the example for Cost Method, let us assume that $100,000 purchase was financed taking out a loan in which the down payment was only $20,000. Out of pocket expense in this case will only be $70,000, which includes a down payment of $20,000 plus $50,000 for repairs and upgrade. If the property after rehab is valued at $200,000, the equity will be $130,000.

200,000 – (20,000 + 50,000) = 130,000

The ROI, in this case, will be whopping 185% ($130,000 equity divided by $70,000 out of pocket expenses expressed as a percentage).

The increase in ROI is attributable to leverage applied to the loan by only 20% down payment.

Real estate investors prefer the out-of-pocket method for achieving higher ROI results by applying leverage by putting minimum down payment for the property.

Note of Caution – When calculating ROI, cited in the above examples, care should be taken in adding costs of marketing and brokerage associated with selling. It is also prudent to remember that properties don’t always sell at market value. The actual ROI in all probability will be lesser than shown in the example.

ROI will increase if part of the property is tenanted during the rehab process. Rents will add to the cash flow and income.

ROI will also be affected by payment of interest rate during the period of rehab or if the property is refinanced.

The calculations in some cases can become very complex. It is advisable to use investment software /calculators or services of an accountant to arrive at the correct figure.