When getting started with any new job, hobby, sport, investment, etc., there are always new terminology and acronyms we must learn. This is no different when it comes to real estate investing. And although the final equation (make lots of money) is easy for almost anyone to grasp, we still must learn how to navigate from A to Z.
Here is my own personal favorite equation (simple is good):
One of the first equations you will come across in real estate is Capitalization Rate (CAP Rate). The CAP Rate simply looks at the potential return of the investment. The higher the percentage, the larger your return. In its simplest form, it looks at the ratio of gross yearly income generated divided by the cost (value) of the property:
For instance, if we located a $310,000 property that was expected to generate $2100/month in rent, our gross CAP Rate would be:
Real estate investors use the CAP Rate in a similar manner in which stock investors use the P/E Ratio*. These formulas allow for basic, quick calculations to be made to help a person quickly determine if an asset is priced at an attractive valuation.
On the surface, a company sporting a P/E Ratio below 10 usually looks to be cheap. Similarly, a CAP Rate of over 10% will look to be a good deal.
Effective Capitalization Rate
If the CAP Rate looks too good to be true, it usually is. The “true” CAP Rate, known as the Effective CAP Rate, involves more calculations to determine. Whereas the CAP Rate only used gross rental income, the Effective CAP Rate looks at the complete picture, the net rental income. The net rental income, or net operating income, factors in all the costs associated with the rental (HOA fees, insurance, property taxes, vacancies, etc.). It omits both principal and interest payments because it assumes the cost of the property is fully paid for. In its more complete form, the effective CAP Rate is defined as the ratio of net yearly operating income divided by the cost (value) of the property:
Using the same $310,000 property from above, we can calculate the Effective CAP Rate once we know how much the expenses are. If rental income is $2100/month, and we assume $570.75/month is needed for expenses, the net income generated each month is $1529.25. Multiplying by 12 for a given year, this gives us an Effective Cap Rate of:
Net Cash Flow
Now we know that a high CAP Rate is desirable. But what if we need a loan? Then we must consider the principal and interest payments as well. For investing, any real estate deal worth pursuing needs to generate positive cash flow, or at bare minimum, break even. More specifically, the net income generated each month from the rental income must cover all the monthly expenses. In the perfect world, we would not only break even, but generate a tidy profit.
Unfortunately, not all real estate properties are cash flow positive (e.g. single family homes in good school districts are highly coveted, so investors are also competing with homebuyers who can drive up the market price greatly). Depending on the type of property, and/or location, you may very well run into one that fails the cash flow test, so it is important to do the math before committing to a deal.
Here is a pie chart breaking down the typical expenses for a $310,000 rental property, assuming 30% downpayment, and an interest rate of 4.25% (for fixed 30 year mortgage):
Monthly Rental Income: $2100
Principal Payment: -$298.97
Interest Payment: -$768.54
HOA Dues: $-165.00
Property Tax: -$310.00
Property Insurance: -$15.00
Vacancy Reserve: -$42.00
Maintenance Reserve: -$38.75
Net Cash Flow: $461.74
It is always a good idea to budget some margin in place. In this case, we did not allocate any funds to a property manager, which could easily add another $100/month in expenses. But it is nice to know that we have some cushion to do so, should the need arise.
Total Cash Return Rate
The CAP Rate assumes that we will have the full downpayment (100%) ready at the time of closing. This makes for a simple calculation, but the CAP Rate formula doesn’t give us a complete picture on the total return on investment.
In the previous example, the Effective CAP Rate was calculated to be 5.92%, since $18,351 would be returned after one year for an investment of $310,000. But what if we only needed to come up with 1% of the purchase price? Our return would now be a whopping 59%, since we would now only need to come up with $31,000 (1% of $310,000). This type of return on investment is not visible when using just the CAP Rate equation.
The Total Cash Return Rate (TCRR) equation can be used, instead, to ascertain this information. The TCRR formula accounts for the upfront costs. TCRR is defined as (net cash flow + principal payment) divided by the total cost due at signing (downpayment), which does not typically include the closing costs.
Continuing with the same example, if we assume a 30% downpayment of the $310,000 purchase price, we would insert $93,000 in the denominator of the Total Cash Return Rate formula. For a given year, the TCRR would be:
TCRR can be looked at as your yearly percentage yield.
An analogy to stocks would be: we purchase 1x share of (insert property) for $93,000/share. Our dividends (net cash flow + principal) are paid out each month, or twelve times in a year. At the end of the year, we receive $9128.52 in payouts. This would give us an annual dividend yield of 9.82%.
If the rental income increases down the line, and outpaces the increases in HOA, insurance, property tax, etc., then our yield on cost (YOC) would also go up. This would be similar to a stock increasing its dividend payout. Depending on your location, you may be able to increase the rents every year. Finding these prime locations would be like locating your very own dividend aristocrats 🙂
*Obviously, the true valuation of any stock equity, or property cannot be so easily ascertained as to just rely on a single, fail-proof number.
In stocks, the P/E Ratio is a starting point, but we also need to know: P/E relative to the rest of the industry, Trailing P/E, Forward P/E, historic P/E, earnings (growth/decline), revenue (growth/decline), debt-to-equity, etc…
In real estate, the CAP Rate is a starting point, but we also need to know: CAP Rate relative to nearby properties, recent market trends (upward/downward momentum), recent appraisals, rentability, repairs, inspection reports, etc…