Real estate professionals, including home buyers and investors, rely on a few common calculations to quickly gauge the value or attractiveness of a property. Below are a few of the tools used for residential property analysis. These tools can also be used for commercial property analysis.
Return on Investment (ROI)
The ROI is the Net Income divided by the Total Down Payment. It is a very useful number to understand the rate of return and to compare different investment properties. A simple calculation is:
Gross Income – All Expenses = Net Income
Net Income / Total Down Payment
$12,000 / $100,000 = 12% ROI
The 1% Rule is used by landlords to quickly evaluate the rental income of a property versus its cost. The rule states that the monthly income should be equal to or greater than 1% of the acquisition cost. Therefore if a house is purchased for $200,000 then the goal is to generate at least $2000 per month in rental income.
The 70% Rule
The 70% Rule is used as a guide to determine an offer price for a house. It is often used by “flippers” or those who want to remodel and sell a house. The real estate investor must calculate two important numbers and any error in either estimate could result in significant loses for the investor. First the value of the house after all repairs are made must be estimated. This number is referred to as the ARV – After Repair Value. Usually the investor will use recent sales comparables to estimate the ARV. Next the investor must estimate all of his rehab / remodeling expenses, which include holding time and holding costs. Once those two numbers are estimated the home investor’s offer price is calculated as follows:
(ARV x 70%) – All Rehab Expenses = Offer Price
($200,000 ARV x 70%) – $40,000 Rehab Expenses = $100,000 Offer Price
Cash on Cash Return (CCR)
The CCR is expressed as a percentage or a ratio x 100. It measures the cash flow return from the cash invested in the property. It is not a “pure” profitability measure but rather a measure of the cash flow of the property. All investors want a positive cash flow and this measure helps compare different income producing properties. The calculation is:
Before-Tax Cash Flow / Total Cash Invested x 100
$6000 / $60,000 x 100 = 10% CCR
Capitalization Rate (Cap Rate)
The Cap Rate is a ratio and is often used by real estate investors to estimate the value of an income producing property and compare against other properties. The Cap Rate is determined by dividing the Net Operating Income by the Selling Price or Market Value of the property. Note that Net Operating Income is Gross Income minus all expenses but BEFORE deductions for interest on loans, income taxes or depreciation.
Net Operating Income / Selling Price or Market Value
$8000 / $100,000 = .08 or 8% Cap Rate
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