How to Calculate Real Estate Returns

“Investors aren’t rewarded for picking winners; they’re rewarded for uncovering mispricings.”

— Tobias Carlisle, Deep Value

            When you invest in rental property you will own all or a part of the earnings from that asset.  In addition to cash flow you will also receive equity payments and tax deductions which shield some or possibly all of your income.

In real estate when looking at your income statement it should look like this.

Purchase Price: $79,000, $15,800 Down, $2,500 Closing Costs

Cash Flow:			%	Year 1
		Gross Potential Income		$13,200
	-	Vacancy / Bad Debt		$ (660)
	+	Miscellaneous Income
	=	Effective Gross Income		$ 12,540
	-	Operating Expenses	45%	$ (5,902)
	-	Capital Expenditures
	=	Net Operating Income		$ 6,638
	-	Principle and Interest		$ (3,512)
	=	Before Tax Cash Flow		$ 3,125
		Interest Paid		$ (2,350)
		Equity Added		$ 1,162
		Depreciation, Improvements over 27.5 Years		$ (2,298)
		Taxable Income (GPI-OE-Interest-Depreciation)		$ 2,649

Real Estate is commonly valued using two popular metrics Gross Rent Multiple and Capitalization Rate. Gross rent multiple or GRM can be calculated quickly be taking the price of the property and dividing it by the annual gross rent of the property in the example above 79,000/13,200=6.2.

The other calculation is Capitalization Rate or Cap Rate which can be calculated by taking the Net Operating Income and dividing that by the purchase price of the property in the example above 6,638/79,000=8.4%. The Cap Rate isn't going to give you your exact return on investment. However it will give you an idea of what you COULD make if you made a full cash purchase of the property. Because the Cap Rate doesn't take into consideration the costs of financing, the return is unlevered. The Cap Rate should represent the bottom level of your returns, if your estimates for expenses and vacancy are reasonable. To take into consideration the added benefit of leverage, you can take a look at your Cash on Cash returns. This can be calculated by taking the Before Tax Cash Flow and dividing it by the total cash needed to own the property in the example above 3,125/15,800=19.8%.

I believe the most accurate picture of what you're going to get is going to be something I'll call Total Real Estate Yield until someone corrects me. Total RE Yield will be Before Tax Cash Flow + Equity Added / Down Payment + Cash to Close + Equity Added, which is (3,125+1,162)/(15,800+2,500+1,162)=22%.

Real Estate returns typically reflect the market's sentiment for at particular area. If you look at Month's Supply Inventory you can get an idea for the demand in a given area. Attached are 4 Charts looking at MSI in Los Angeles, United States, Lake County Ohio, Cuyahoga County Ohio. You can't possibly look at a single number in real estate and assume a complete picture. But what the hell, here are some charts.

Eric Zunkley Real Estate Blog RSS