We’ve all heard of ROR (Rate of Return) or ROI (Rate of Investment) but do you really understand how they apply to your real estate investments? Along with ROR/ROI let’s look at a couple of other formulas that help quantify good real estate investments.
Those of you who have taken the Professional Real Estate Class you know I emphasize CADS (Cash After Debit Service), and touch on CAP Rate (Capitalization Rate) as two formulas that you need to understand when buying rental property. There is also ROE (Return on Equity) for those investors that have held assets for a long time and want to know what kind of return their equity is getting.
I thought we’d take a little time to explore some of these formulas. Understanding how these formulas are calculated and what goes into them will help you better understand and analyze your investments.
ROR and ROI are the most commonly used formulas to analyze an investment. Investments from real estate, stocks, bonds, art apply ROR/ROI. ROR/ ROI are the ratio of money made (or lost) in relation to the investment made, also known as Capital. The money made will be referred to as the Return; this can be either interest paid or profit.
The ROR/ROI Formula is:
((Return-Capital)/ Capital) = Rate of Return
Example – Invest $100,000 in real estate and a year later the property is worth $125,000. The ROR/ ROI is 25%, calculated as follows:
125,000-100,000 = 25,000/100,000 = 25%
Most of the time Cap Rate (Capitalization Rate) is used for estimating the value of commercial income property. Cap Rate represents the projected return for one year, if you purchased the property with all cash.
The Cap Rate formula is:
Operation Revenue – Operating Expense = (Net Operating Income) NOI / Sale Price.
Example – Property has a NOI of $125,000 and sales price of $1,125,000.
$125,000/$1,125,000 = 11.1% Cap Rate
Cap Rate is a useful formula to know when looking at commercial/rental property however it doesn’t take into consideration the debt, the cost of the debt or cash flow. The value of the investment and the ROR are important, but how much cash is going into the bank every month is a big factor. The formula used to find that out is, CADS. CADS uses actual income (not scheduled), all operating expenses and the cost of Debt Service (cost of loan payments).
The CADS formula is:
Operating Revenue – Operating Expense = NOI – Debt Service= CADS
Example – A 6 unit apartment building has Operating Revenue of $3,600, Operating Expense is $1,495 making NOI $2,105 and Debt Service of $1,373 has a CADS of $732.00.
$3,600-$1,495= $2,105- $1,373=$732.00
Many investors who have owned investment properties for a long time have exhausted depreciation (a major tax benefit); this in turn can create a poor annual return on their equity. To figure out what the return on equity is, we’ll use the following formula known as ROE.
The ROE formula is: Net Income/Estimated Net Equity = ROE
a) Annual gross income = monthly rent(s) times 12
b) Annual Expenses = all expenses including mortgage payment, insurance, taxes, maintenance
c) Annual Net Income = A-B
d) Estimate the Net Equity of your property: Start with the FMV of the property (you can use one of the websites that we’ve used with in class or ask your Real Estate Broker) then subtract the purchase price plus any capital improvements.
Example – 12 unit apartment building:
A) Annual Rents = $216,000
B) Annual Expenses = 120,840
C) Annual Net Income = 95,160
D) Net Equity = 450,000
95,160/450,000 = 21%
These formulas are very important for real estate investors, they define what are good deals and what are deals that you should “let go.” These formulas will also help you remove the emotion from a deal.
Hope to see many of you in my online class this August.