|
|
|
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. |
|
|
