5 Key Terms & Calculations to Ensure Accurate Rental Property Evaluations
Updated: Feb 26, 2019
Knowing how to evaluate and analyze properties to create an accurate picture of your investments is an integral component for any real estate investor or firm.
As we all know, real estate can be a very lucrative vehicle to earn extra income, replace your 9-5 and build a great financial foundation for you and your family. However with any investment you make, you expose yourself to a certain level of risk. With risk comes fear and fear is one of the main reasons why individuals prolong investing.
With that being said, there are multiple ways to mitigate your risk and increase your odds of a successful investment. There are certain calculations within your analysis that will determine if you should move forward with an investment or you should move onto the next one.
Everybody always wonder's what the process is when you are looking for properties to invest in? How do you know if this is the property that you should pull the trigger on and invest your hard earned money into. As a real estate investor, you should have a specific criteria that will determine if and when you invest. Your analysis will help spit out numbers that determine if the investment fits your criteria.
People tend to make the concept of investing in real estate more difficult than it really is. In reality it can be fairly simple and if you understand basic math, then you should have no problem with evaluating a property. The condition and location is one aspect of the property but we will be analyzing the income stream associated with the subject property.
What are the 2 most important results any real estate investor looks for? Cash Flow and Equity. What determines your cash flow on a property? Income and Expenses. What determines your equity? What you purchased the property for compared to what it's full value is. (discounted purchase).
So if you are considering investing in real estate, please take the time to learn some simple calculations to increase your odds of a good investment.
Calculations To Produce Solid Real Estate Investments
Now that you understand that the numbers involved in a real estate investment are one the most important criteria to be successful, lets discuss some of the key terms and concepts you need to know in order to evaluate a rental property.
1) Gross Operating Income - Maximizing your rent and other sources of income is very important for your rental property investment to be successful. Understanding market rents and what it takes to get to those market rents will allow you to maximize your GOI while also creating systems and processes to improve management.
Gross operating income is the total amount of income produced through rent and other sources (coin operated laundry) minus vacancy and credit loss.
Here is a simple way to go about calculating the gross operating income of a property.
Gross Scheduled Income (All Units Rented)
- Vacancy and Credit Loss
+ Other sources of Income
= Gross Operating Income
I can hear you now. What is gross scheduled income, vacancy and credit loss. Well lets discuss them quick, they are easy terms to understand.
Gross Scheduled Income - This is the total amount of rental income that you will expect to receive if your property is fully rented for 365 days a year.
Vacancy Loss - The loss of income resulting in units being unoccupied.
Credit Loss - This number will be much less than vacancy loss and may not apply to your properties but it still needs to be added. It is the result of checks not arriving, clearing in the bank or lack of payment from a tenant. (believe me it happens)
The vacancy and credit loss on a specific investment will vary. Each farm area will be exposed to lower or higher vacancy rates. Understand your market and use a conservative estimate when evaluating your rental properties. A common percentage used throughout the industry is 5-10% but as stated this number will vary depending on your location and overall condition of the unit.
2) Net Operating Income - This will be used as a profitability formula to determine your expected profit on a property, not taking into consideration debt service. In other words this formula will help determine your expected cash flow on a property (if you were purchasing the property for cash)
Net Operating Income is the annual income produced from a rental property minus all operating expenses that you incur while holding your property (besides mortgage payments)
So how do we arrive at the Net Operating Income? The formula is also fairly simple.
Gross Operating Income
- Operating Expenses
= Net Operating Income
The reason this calculation can be somewhat difficult to predict is due to accurately acquiring the operating expenses for any given property. The fact is that most landlords severely underestimate the costs of operating a rental property. This is why it is important to know an average operating expense % for the subject area you are looking to invest in.
Here are some potential operating expenses that you should consider during your evaluation:
Repairs and Maintenance
These are the most popular operating expenses that you have the potential to incur throughout the life of owning a rental property. Your NOI will be used as a metric by your lenders to help put a value on the investment. This valuation is more commonly used to help value commercial properties (5+ units) but is a value approach used by residential appraisers as well.
3) Cap Rate - The return on investment is an important figure that all real estate investors consider when making a purchase. Your ROI evaluates how much money was made on your investment as a percentage of the purchase price. This number is equivalent to the return on investment you would see if you were to pay all cash for a property.
Cap Rate (Capitalization Rate) is the ratio between the Net Operating Income and the properties value (price).
This is also a calculation that lenders, banks and appraisers will use to evaluate an assets value.
The formula we use to determine cap rate is:
Net Operating Income
/ Properties Price
= Cap Rate
However, this calculation will only give you your potential ROI on a property that was purchased in cash. If you plan to take a mortgage out on a property, you will have to account for a few more steps to generate your ROI.