Basic Real Estate Calculations for those Considering Investing in Real Estate as a Business
When investing in Real Estate as an investment and not as a home, the most important calculations you should know are:
- Net income:- This is the projected annual income less the projected annual expenses in owning the property. It is useful to also calculate the net income per month. The net incomes does not normally cover the debt payments each month, since it is believed that this is netted off against the value of the property. It therefore usually just covers the expenses in maintaining the property. Expenses such as janitorial, landscaping and insurance.
- Cash flow:- This is the projected monthly net income (see net income) less the monthly debt financing payment. This calculation is particularly important because it is possible that the property is showing a positive net income each month, but this monthly positive net income cannot cover the monthly debt payments. As such you could find yourself out of pocket each month. The property could be a good purchase in the long term due to value appreciation, but due to negative cash flow you could find yourself bankrupt, because you are not able to meet monthly debt financing.
- Return on investment:- This is a useful figure. It is calculated by dividing the annual cash flow (see above) by the total investment and converting to a percentage. It is useful since it allows you to measure the return on your investment. This figure can be used to compare between alternative investments. Take for instance if one investment yields a 6% return on investment and another a 5% return then one may be advised to select the property that offers the larger return on investment. Also it is a useful figure to compare between depositing the investment sum in a government bond which may yield 5% with no risk. This calculation and comparison tells you that the Real Estate investment, which has risks, should yield considerably more than a fixed deposit of government bond yield.
- Cap rate (net income/property price):- This figure is calculated by dividing the net income (see above) by the property purchase price and converting to a percentage. Once again this figure allows you to compare between alternative investments. One can compare the cap rates between investing in Real Estate or investing in paper such as shares or in government bonds. This brings home the point that investing in Real Estate is not a ‘nice to do’ activity but one that should yield a better cap rate than other alternative investments that may be available in the market.
It is advisable when starting out in Real Estate investment to start small and grow as your competence grows. One can star out with a small apartment or single family home and do some renovating or remodeling either to rent or sell.
If you decide to invest to rent then you are looking for a positive cash flow (see above). Most Real Estate investors that work to gain positive cash flow, accumulate a portfolio of properties building their positive cash flow over time and thereby hedging for risks in any one property.
If you decide to sell then you are looking for a Capital gain (recently called Flipping), which is your total net profit of total revenue from the sale, less all expenses including financing and closing costs.
We hope this knowledge inspires you to continue your research and hopefully start investing in Real Estate in the near future.