3 Real Estate Formulas to Keep in Mind when Assessing Income-Producing Properties

By January 15, 2017 Blog, Resources

There are many factors that go into buying a property — size, location, finishes — the list goes on and on. When searching for a multi-family there are additional considerations, one of them being cash flow. Depending on whether you’re looking to buy a pure investment or owner-occupy the property may impact where the cash flow factor stacks up against your other priorities.

When investing, there are no hard and fast rules. Everybody has their own investment objectives and a strategy for fitting real estate into their lifestyle. Perhaps your day job offers you flexibility, so you have time for a fixer upper. Another buyer may be tied to his desk during the workweek and is most interested in turnkey. There is no right or wrong answer and cash flow may compete with or compliment other important factors like appreciation, exit strategy, and ease of management.

No matter what, it doesn’t hurt to have an awareness of some common real estate formulas. Just remember, a house is lot more than a math equation. When buying a small multi-family, be sure to consider the entire picture. The math is just one piece of the puzzle. Below are some key formulas to familiarize yourself with.

The 1% Rule

My favorite financial measure for calculating ROI on a small multi-family is the 1% rule. I personally seek out properties that generate 1% of the purchase price + rehab costs per month. In simpler terms, gross monthly rent should be equal to or greater than 1% of the value of the property.

Here’s an example:

You purchase a two-family for $350,000 + $50,000 for rehab, so you’re into the house for $400,000. If you’re following the 1% rule, you should be striving for this property to bring in $4,000 in rent per month.

*In some areas of the country, the 2% rule can be applied for small multi-families, but in Boston and the North Shore, it’s difficult to find 2% rule properties.

 

Cap Rate (Capitalization Rate)

Another solid indicator is cap rate. The equation is net operating income divided by the cost (or value) of the property. In my personal investments, I strive for a 7%+ cap rate.

Here’s how to calculate cap rate on a hypothetical property:

You’re considering buying a three family house for $480,000. It needs about $50,000 in updates, and you estimate it could bring in $54,000 in gross income. First calculate the net operating income by subtracting the property’s operating costs from the gross income. Property expenses include taxes, trash removal, maintenance, water and sewer, utilities, capital improvements, etc. Then, divide this number by the cost.

  • Don’t forget to account for all income streams when calculating gross income, ie rent plus any additional cash from other sources (washer & dryer coin op, on-site parking/storage)
  • When determining property value, make sure to consider purchase price AND rehab costs.

$54,000 (total gross income) – $20,000 (operating costs) = $34,000 (NOI)

$480,000 (purchase price) + $50,000 (rehab) = $530,000 (Property value)

34,000/530,000 = 10.2%

Pros: This calculation takes into account all income and operating expenses

Cons: It does not take into account debt service costs

Loan to Value (LTV)

The loan to value equation applies when purchasing or refinancing. Loan to value is simply the percentage a lender is willing to give you based on the appraised value of the property. Typically, lenders are willing to give anywhere from 70 to 80%, and sometimes 90+% loan to value.

Purchase Example:

Say you want to buy a four unit for $600,000. Your lender is willing to finance up to an 80% LTV, meaning the bank will shell out up to $480,000.

Refinance Example:

Let’s say you purchased the above four family for $600,000. You then spent $100,000 on renovations to improve the property value. After the renovations were complete, the property appraised for $800,000. Depending on your lender, you could refinance to an 80% LTV, which is equal to $640,000. In this situation, you could pull out $160,000 ($640,000-$480,000) from the property through a refinance and apply this money elsewhere. Your new loan would be at $640,000 at current interest rates.

Next Steps

Contact me if you’re starting your search for a small multi-family. I am happy to help you assess properties and “dig into the numbers” on your investments.

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